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Learning Objectives

• Utilize the money multiplier formulate to determine how banks create money
• Analyze and create T-account balance sheets
• Evaluate the risks and benefits of money and banks

Money Creation by a Single Bank

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is shown in Figure 13.6. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate, either.

Figure 13.6 Singleton Bank’s Balance Sheet: Receives $10 Million in Deposits

Singleton Bank is required by the Federal Reserve to keep $1 million on reserve—10 percent of total deposits. It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank; for now, we will keep it simple and not put interest income on the balance sheet. Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.

This change in business plan alters Singleton Bank’s balance sheet, as shown in Figure 13.7. Singleton’s assets have changed; it now has $1 million in reserves and a loan to Hank’s Auto Supply of $9 million. The bank still has $10 million in deposits.

Figure 13.7 Singleton Bank’s Balance Sheet: 10 Percent Reserves, One Round of Loans

Singleton Bank lends $9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This loan is an asset because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check for the $9 million. Hank deposits the loan into his regular checking account with First National. The deposits at First National increase by $9 million and its reserves also increase by $9 million, as Figure 13.8 shows. First National must hold 10 percent of additional deposits as required reserves but is free to loan out the rest.

Figure 13.8 First National’s Balance Sheet

Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember, the definition of M1 includes checkable—demand—deposits, which can be easily used as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously, these deposits will be drawn down as Hank’s Auto Supply writes checks to pay its bills. But the bigger picture is that a bank must hold enough money in reserves to meet its liabilities; the bank loans out the rest. In this example so far, bank lending has expanded the money supply by $9 million.

Now, First National must hold only 10 percent as required reserves ($900,000) but can lend out the other 90 percent ($8.1 million) in a loan to Jack’s Chevy Dealership, as shown in Figure 13.9.

Figure 13.9 First National’s Balance Sheet

If Jack’s deposits the loan into its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 13.10 shows.

Figure 13.10 Second National’s Balance Sheet

How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up being deposited in other banks, which increases deposits and, in essence, the money supply.

Link It Up

Watch this video to learn more about how banks create money.

The Money Multiplier and a Multi-Bank System

In a system with multiple banks, the initial excess reserve amount that Singleton Bank decided to lend to Hank’s Auto Supply was deposited into Frist National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, the amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be multiplied as it is spent in the economy and then re-deposited in other banks.

Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is

The money multiplier is then multiplied by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work It Out feature to walk through the multiplier calculation.

Cautions About the Money Multiplier

The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in a recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.

The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are redeposited and loaned out, again and again.

Finally, the money multiplier depends on people redepositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as mattress savings, or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.

Money and Banks—Benefits and Dangers

Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.

But the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money, such as business investment, home construction, and car manufacturing. The Great Recession of 2008–2009 illustrated this pattern.