¶ … Banks Create Money

M1 is the basic measure of our money supply and includes coins and currency in people's hands plus the funds available in checking accounts (Beale). Banks may either increase or decrease the checking deposit component of the money supply by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve that defines what fraction of their customer's deposits must be set aside as required reserves (Obringer). The reserve requirement is currently 3% to 10% of a bank's total deposits. Banks may lend out whatever is left over after they have met the reserve requirement.

The process where banks make loans equal to the amount of their excess reserves and create new checkbook money is known as multiple deposit creation (Beale). The money multiplier is the number of deposit (loan) dollars that the banking system can create from $1 of excess reserves (Larsson, 2005). The formula for the money multiplier is:

Required Reserve Ratio = Money Multiplier.

If the Federal Reserve requirement is 10%, the money multiplier is 10, meaning that banks can lend out 90% of every dollar they receive as illustrated by the following example of multiple deposit creation (Larsson, 2005):

John deposits $10,000 into his checking account at Bank a.

Bank a Deposit: $10,000

Reserve (10%): $1,000

Lendable Amount: $9,000

Mary borrows $9,000 from Bank a and buys a car. The car dealer then deposits $9,000 into their account at Bank B.

Bank B

Deposit: $9,000

Reserve (10%): $900

Lendable Amount: $8,100

Mark borrows $8,100 from Bank B. And has surgery. The doctor then deposits $8,100 into his account at Bank C.

Bank C

Deposit: $8,100

Reserve (10%): $810

Lendable Amount: $7,290

This process continues until the lendable amount is 0. When M1 is measured, the original $10,000 deposit will have created a total of $100,000 in deposits system wide (Larsson, 2005).

Bibliography

Beale, L. How banks create money. Retrieved October 20, 2006 from Web site: http://ecedweb.unomaha.edu/ve/library/HBCM.PDF

Larsson, T. (2005, February 1). How banks create money. Retrieved October 20, 2006 from Web site: http://www.gold-investor.com/article.php/20050201204730229

Obringer. L.A. How banks work. Retrieved October 20, 2006 from Web site: http://money.howstuffworks.com/bank1.htm