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Learning Objectives. Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system. Describe the process of money creation (destruction), using the concept of the deposit multiplier. Describe how and why banks are regulated and insured.
- Money Creation by A Single Bank
- The Money Multiplier in A Multi-Bank System
- Cautions About The Money Multiplier
Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let’s see how. 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 a...
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 First 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...
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 recession, banks are li...
Money creation, or money issuance, is the process by which the money supply of a country, or an economic or monetary region, is increased. In most modern economies, money is created by both central banks and commercial banks. Money issued by central banks is a liability, typically called reserve deposits, and is only available for use by ...
Money creation in a fractional reserve system. Most people assume that the government prints money, and that is how money is created. That is not entirely true. Watch this video to find out the role that banks play in the creation of the money supply.
- 8 min
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 re-deposited and loaned out, again, and again.
Utilize the money multiplier formula to determine how banks create money in an environment of limited reserves. Analyze and create T-account balance sheets. Evaluate the risks and benefits of money and banks. Banks and money are intertwined. It is not just that most money is in the form of bank accounts.
This is how banks “create” money and increase the money supply. When a bank makes loans out of excess reserves, the money supply increases. We can predict the maximum change in the money supply with the money multiplier. Key Terms. Key Takeaways. Assets and Liabilities.
