How banks create money

¶ … 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