Fractional Reserve Banking and Money Creation Review for AP Economics

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By — McGraw-Hill Professional
Updated on Mar 4, 2011

Review questions for this study guide can be found at:

Money, Banking, and Monetary Policy Review Questions Review for AP Economics

Main Topics: Fractional Reserve Banking, Money Creation, The Money Multiplier

If you asked 10 bank tellers in your hometown, "do you create money here?" I'm guessing that 9 or 10 of them would reply, "no way." They're wrong. The fractional reserve system of banking, plus the bank's profit motive, creates money and opens the door for the Fed to promote or inhibit such money creation.

Fractional Reserve Banking

Fractional reserve banking is a system in which only a fraction of the total money supply is held in reserve as currency. The short story that follows illustrates how fractional reserve banking might have evolved.

Eli's Community Bank (ECB) opens its doors and is now accepting deposits from citizens who want a safe place to put their money. Eli promises to always keep 100 percent of their money on hand so that if a person needs to buy groceries, he or she can simply withdraw some money and take it to the store.

One day, a citizen came up to the bank asking to borrow some money to start a lemonade stand, but Eli had to turn her down because if any of his customers came to withdraw money for groceries, and found that it was not in the vault, they would be extremely irritated. After a month or so, Eli observes that on any given day, there are very few withdrawals and most of the time the deposited money just sits there in the vault, doing nothing.

Eli decides, just to be safe, to hold a small percentage of his total deposits in the vault to cover any daily withdrawals, and earn some interest income by lending out the rest to households or small businesses. He even realizes that he must offer a small rate of interest to his depositors to compensate them for that "whole time value of money thing." The fraction of total deposits kept on reserve is called the reserve ratio. Each time he receives a deposit, he puts that fraction in the vault and lends the rest. This process is the foundation for money creation and the Fed's ability to conduct monetary policy.

Money Creation

A specific example of how the fractional reserve system can multiply one new bank deposit into new created money illustrates the process of money creation.

The reserve ratio is 10 percent. In other words,

    Reserve ratio (rr) = required reserves/total deposits = .10

One way to see how checking deposits turn into loans, and how loans turn into new money is to create a basic T-account, or balance sheet. The idea of a balance sheet is to show the assets and liabilities of a bank. In our example, total assets must equal total liabilities.

Asset. Anything owned by the bank or owed to the bank is an asset of the bank. Cash on reserve is an asset and so are loans made to citizens.

Liability. Anything owned by depositors or lenders to the bank is a liability. Checking deposits of citizens or loans made to the bank are liabilities to the bank.

Step 1. Katie takes $1000 from under her mattress, deposits it at ECB, and opens a checking account. ECB must put $100 in required reserves, but the remaining $900 are excess reserves and can be either kept on reserve or lent.

Step 2. ECB lends all $900 in excess reserves to Bob, a local farmer. This loan does not yet count as newly created money.

Step 3. Bob uses his $900 at Tractor Supply, which has a checking account with ECB. Checking deposits have now increased by $900 and this is new money. ECB must keep $90 as required reserves and there are now $810 of excess reserves.

Step 4. ECB makes an $810 loan to Brent, who is looking to buy some furniture. Brent spends $810 at Furniture Factory, which also banks with ECB, increasing checking deposits by $810. ECB must keep $81 in required reserves and there are now $729 in excess reserves.

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