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Banks create money during their normal operations of accepting deposits and making loans. In this
example we'll use M1 as our definition of money. (M1 = currency in our pockets and balances in our
checking accounts.) When a bank makes a loan it creates money. For example when I got a loan to buy my
boat, my credit union called an told me that the loan was approved and that I should come in and get the
check. I told them to just deposit it in my checking account. So they did. they turned on their computers,
typed in my account number, and added the loan to my checking account balance. I now had more money
(M1). The bank created this money when they gave me the loan.

To learn how banks create money during their normal activities of accepting deposits and making loans lets
assume that a $10 bill is deposited in the First National Bank (FNB). We will use the balance sheets of
banks to see the effects. Our balance sheets will only show the CHANGES made to them.

Major Point: An initial increase in funds available to the banking industry results in a MULTIPLE increase
in the money supply.

Student Stumbling Blocks

1. The fact that banks can create money seems somewhat like magic. Part of the mystery lies in
forgetting that checkable deposits are money. Many students fall back on their old understanding
of money as currency and forget that the bulk of the money supply is in checkable deposits.
2. Students without an accounting background may not understand T-accounts. Especially confusing
is the idea that checkable deposits are liabilities for banks. Emphasize that deposits belong to the
depositor and can be withdrawn at any time. Thus, they are not assets for the bank. On the asset
side there will be reserves or cash to back up the claim when the depositor first puts his/her money
in the bank. When the depositor withdraws funds or writes a check to someone who banks
elsewhere, both deposits and reserves decrease in the home bank. Problems at the end of the
chapter, or those found in the Study Guide or the computer tutorial provide practice.
3. The distinction between the money-creating potential of a single bank and the multiplied potential
of the entire system is difficult for students to grasp. When discussing the consolidated balance
sheet concept, it may be helpful to have students imagine that all banks are linked through an
imaginary island parent bank where there is no cash and no leakages of reserves or deposits from
this system. This may help them understand the difference between the situation in which a single
bank is one among many and the system as a whole.

The reserve ratio is the percentage of depositors' bank balances that the banks have on
hand. So if a bank has $10 million in deposits, and $1.5 million of those are currently in the bank,
then the bank has a reserve ratio of 15%. In most countries banks are required to keep a
minimum percentage of deposits on hand, known as the required reserve ratio. This required
reserve ratio is put into place to ensure that banks do not run out of cash on hand to meet the
demand for withdrawals.

Bank reserves at central bank

When a central bank is "easing", it triggers an increase in money supply by purchasing government
securities on the open market thus increasing available funds for private banks to loan through fractional
reserve banking (the issue of new money through loans) and thus grows the money supply. When the
central bank is "tightening", it slows the process of private bank issue by selling securities on the open
market and pulling money (that could be loaned) out of the private banking sector. It reduces or increases
the supply of short term government debt, and inversely increases or reduces the supply of lending funds
and thereby the ability of private banks to issue new money through debt.
The operative notion of easy money is that the central bank creates new bank reserves (in
the US known as "federal funds"), which let the banks lend out more money. These loans
get spent, and the proceeds get deposited at other banks. Whatever is not required to be
held as reserves is then lent out again, and through the magic of the "money multiplier",
loans and bank deposits go up by many times the initial injection of reserves.

Why Is the Money Supply Important?

Because money is used in virtually all economic transactions, it has a powerful effect
on economic activity. An increase in the supply of money puts more money in the
hands of consumers, making them feel wealthier, thus stimulating increased
spending. Business firms respond to increased sales by ordering more raw materials
and increasing production. The spread of business activity increases the demand for
labor and raises the demand for capital goods. In a buoyant economy, stock market
prices rise and firms issue equity and debt. If the money supply continues to expand,
prices begin to rise, especially if output growth reaches capacity limits. As the public
begins to expect inflation, lenders insist on higher interest rates to offset an
expected decline in purchasing power over the life of their loans.

What Determines the Money Supply?

Federal Reserve policy is the most important determinant of the money supply. The
Federal Reserve affects the money supply by affecting its most important
component, bank deposits.

Here's how it works. The Federal Reserve requires commercial banks and other
financial institutions to hold as reserves a fraction of the deposits they accept. Banks
hold these reserves either as cash in their vaults or as deposits at Federal Reserve
banks. In turn, the Federal Reserve controls reserves by lending money to banks and
changing the "Federal Reserve discount rate" on these loans and by "open-market
operations." The Federal Reserve uses open-market operations to either increase or
decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury
securities by writing a check drawn on itself. The seller of the Treasury security
deposits the check in a bank, increasing the seller's deposit. The bank, in turn,
deposits the Federal Reserve check at its district Federal Reserve bank, thus
increasing its reserves. The opposite sequence occurs when the Federal Reserve sells
Treasury securities: the purchaser's deposits fall and, in turn, the bank's reserves
fall.

If the Federal Reserve increases reserves, a single bank can make loans up to the
amount of its excess reserves, creating an equal amount of deposits. The banking
system, however, can create a multiple expansion of deposits. As each bank lends
and creates a deposit, it loses reserves to other banks, which use them to increase
their loans and, thus, create new deposits, until all excess reserves are used up.
In a system with fractional reserve requirements, an increase in bank reserves can
support a multiple expansion of deposits, and a decrease can result in a multiple
contraction of deposits. The value of the multiplier depends on the required reserve
ratio on deposits. A high required-reserve ratio lowers the value of the multiplier. A
low required-reserve ratio raises the value of the multiplier.

Even if there were no legal reserve requirements for banks, they would still maintain
reserves with the Federal Reserve, whose ability to control the volume of deposits
would not be impaired. Banks would continue to keep reserves to enable them to
clear debits arising from transactions with other banks, to obtain currency to meet
depositors' demands, and to avoid a deficit as a result of imbalances in clearings.

The currency component of the money supply is far smaller than the deposit
component. The Federal Reserve and the Treasury supply the banks with the
currency their customers demand, and when their demand falls, accept a return flow
from the banks. The Federal Reserve debits banks' reserves when it provides
currency, and credits their reserves when they return currency. In a fractional
reserve banking system, drains of currency from banks reduce their reserves, and
unless the Federal Reserve provides adequate additional amounts of currency and
reserves, a multiple contraction of deposits results, reducing the quantity of money.

Currency and bank reserves added together equal the monetary base, sometimes
known as high-powered money. The Federal Reserve has the power to control the
issue of both components. By adjusting the levels of banks' reserve balances, over
several quarters it can achieve a desired rate of growth of deposits and of the money
supply. When the public and the banks change the ratio of their currency and
reserves to deposits, the Federal Reserve can offset the effect on the money supply
by changing reserves and/or currency.

The Federal Reserve's techniques for achieving its desired level of reserves—both
borrowed reserves that banks obtain at the discount window and nonborrowed
reserves that it provides by open-market purchases—have changed significantly over
time. At first the Federal Reserve controlled the volume of reserves and of borrowing
by member banks mainly by changing the discount rate. It did so on the theory that
borrowed reserves made member banks reluctant to extend loans, because their
desire to repay their own indebtedness to the Federal Reserve as soon as possible
was supposed to inhibit their willingness to accommodate borrowers