Source: Principles of Macroeconomics textbook, Ch. 13
Tags: banking, commercial banks, fractional reserve banking, required reserves, excess reserves, deposit multiplier, money creation, loans, loanable funds market
Difficulty: Intermediate
Prerequisites: Part 1 of these notes (what money is, M1, M2, purchasing power). You need to understand what the money supply is before you can understand how banks expand it.
Banks are not just vaults that store money. They are profit-seeking businesses that take in deposits and lend most of them out, keeping only a fraction in reserve. This "fractional reserve" system is the mechanism by which the banking system creates new money. One dollar deposited can support several dollars of loans across the banking system. This section explains how that multiplication works, why it has limits, and why it matters for the broader economy.
Banks accept deposits and lend out everything beyond what regulators require them to hold in reserve. Because each loan becomes a deposit somewhere else, the banking system multiplies an initial deposit into a larger total money supply. The deposit multiplier sets the theoretical ceiling on that expansion, but the actual expansion is always smaller.
Commercial bank
A privately owned, profit-seeking institution that accepts deposits and extends loans. In simple terms, it is the high-street bank most people use for current accounts and mortgages.
Savings and loan (S&L)
A financial institution that traditionally focuses on accepting savings deposits and making mortgage loans. Think of it as a specialised bank for housing finance.
Credit union
A member-owned, not-for-profit financial institution that offers many of the same services as a commercial bank. Members typically share a common bond, such as an employer or community.
Required reserves
The fraction of deposits that banks are legally obligated to hold as reserves (vault cash or deposits at the Federal Reserve). In simple terms, it is the portion of your deposit the bank is not allowed to lend out.
Excess reserves
Reserves held above and beyond the required amount. These are the funds a bank is free to lend or invest. Think of them as the bank's lending capacity.
Fractional reserve system
A banking system in which banks hold only a fraction of deposits as reserves and lend out the remainder. This is the system used in the United States and most of the world.
Deposit multiplier
The maximum amount by which the money supply can expand for each unit of new reserves in the banking system. Calculated as 1 divided by the reserve requirement ratio. In simple terms, it tells you how many times a single deposited dollar can be "recycled" through the banking system.
Capital market (loanable funds market)
The market that brings together savers (who supply funds) and borrowers (who demand funds). Banks play a central intermediary role in this market.
The banking industry includes commercial banks, savings and loans, and credit unions.
Banks are profit-seeking institutions. Their main revenue comes from the interest they earn on loans and investments, minus the interest they pay to depositors.
Banks serve as intermediaries in the capital market (loanable funds market), connecting people who want to save with people who want to borrow.
Banks attract deposits by offering services and paying interest. Deposits are liabilities to the bank (the bank owes that money back to the depositor).
Most deposits are lent out or invested, generating interest income for the bank.
Banks hold a portion of deposits as reserves, either as vault cash or as deposits with the Federal Reserve, to meet daily withdrawal demands.
Under this system, banks are required to hold only a fraction of their deposits as reserves (required reserves).
Vault cash and deposits held at the Federal Reserve both count as reserves.
Anything above the required reserves is excess reserves. Banks can use excess reserves to extend new loans and make investments.
When a bank receives new deposits, the excess reserves give it the capacity to make additional loans, which expands the money supply.
The process works in a chain:
Bank A receives a new deposit of £1,000. If the reserve requirement is 10%, the bank must hold £100 and can lend £900.
The borrower spends the £900, and it ends up deposited at Bank B. Bank B holds £90 in reserve and lends £810.
Bank C receives £810, holds £81, lends £729. The cycle continues.
The theoretical maximum expansion is calculated by the deposit multiplier: 1 / reserve requirement. At a 10% requirement, the multiplier is 10, so an initial £1,000 deposit could theoretically expand the money supply by up to £10,000.
Some people hold currency rather than depositing it. Cash held outside banks cannot be re-lent.
Some banks choose not to lend out all their excess reserves, especially during uncertain economic times. They may hold extra reserves as a buffer.
Both of these "leakages" reduce the actual deposit multiplier below its theoretical ceiling.
A lower reserve requirement means banks can lend a larger share of deposits, producing a larger multiplier and greater money supply expansion.
A higher reserve requirement means banks must hold more back, producing a smaller multiplier and less expansion.
The fractional reserve requirement therefore places a ceiling on potential money creation from any given injection of new reserves.
Deposit multiplier (potential)
Deposit multiplier = 1 / Reserve requirement ratio
Example: If the reserve requirement is 20% (0.20), the potential deposit multiplier is 1 / 0.20 = 5. Each new dollar of reserves could expand the money supply by up to $5.
When a central bank injects reserves into the banking system (through open market operations, covered in Part 3), it relies on this multiplier process to amplify the effect. During the 2008 financial crisis, banks accumulated enormous excess reserves rather than lending them out, which meant the actual multiplier was far smaller than the theoretical one. This is why massive reserve injections by the Fed did not immediately produce proportional increases in the money supply.
"Banks lend out the money depositors put in, so no new money is created." The depositor still has access to their funds (via checks or withdrawals), and the borrower now has spendable money too. The money supply has genuinely increased.
"The deposit multiplier tells you exactly how much the money supply will grow." The multiplier gives the theoretical maximum. The actual expansion is always less because of cash leakages and banks holding excess reserves voluntarily.
"A bank can lend out all of its deposits." No. It must hold at least the required reserve fraction. Lending out everything would leave it unable to meet withdrawal demands and would violate regulations.
"Reserves are money sitting idle." Required reserves serve a regulatory and stability function. Excess reserves represent unused lending capacity, which is why the Fed pays attention to them.
⚠️ Be able to calculate the deposit multiplier given a reserve requirement ratio. This is one of the most commonly tested quantitative questions in this chapter.
⚠️ Know the difference between required reserves and excess reserves, and be able to compute each from a deposit figure and a reserve requirement.
⚠️ Understand why the actual multiplier is always less than the potential multiplier. Exam questions often ask you to explain the two reasons (currency leakage and voluntary excess reserves).
⚠️ Be comfortable walking through a multi-bank deposit expansion example step by step.
True or False: Under a fractional reserve system, banks hold 100% of deposits as reserves.
Fill in the blank: The deposit multiplier equals 1 divided by the ________.
True or False: If the reserve requirement is 25%, the potential deposit multiplier is 4.
Fill in the blank: Reserves above the legally required amount are called ________ reserves.
True or False: The actual deposit multiplier is always equal to the potential multiplier.
(Answers: 1. False, they hold only a fraction. 2. reserve requirement ratio. 3. True. 4. excess. 5. False, the actual is always less.)
Q: What is the fractional reserve system, and why does it allow banks to create money?
A: The fractional reserve system requires banks to hold only a fraction of deposits as reserves and permits them to lend the rest. Because each loan is spent and re-deposited at another bank, which then lends a portion of that deposit, the total money supply expands beyond the original deposit.
Q: If the reserve requirement is 10% and a bank receives a new deposit of $5,000, how much can it lend? What is the potential total expansion of the money supply?
A: The bank must hold $500 (10% of $5,000) as required reserves and can lend $4,500. The potential deposit multiplier is 1 / 0.10 = 10, so the potential total expansion is $5,000 x 10 = $50,000.
Q: Give two reasons the actual deposit multiplier is smaller than the potential multiplier.
A: (1) Some individuals hold currency rather than depositing it in banks, removing those funds from the re-lending chain. (2) Some banks choose to hold excess reserves rather than lending them all out, especially during periods of economic uncertainty.
Q: How does the reserve requirement affect the money supply?
A: A lower reserve requirement increases excess reserves, allowing more lending and a larger deposit multiplier, which expands the money supply. A higher reserve requirement does the opposite, reducing the multiplier and contracting the potential money supply.
This connects directly to Part 3 of these notes, where the Federal Reserve's tools (open market operations, discount rate, interest on reserves) inject or drain reserves from the banking system. The multiplier process is what amplifies those Fed actions into larger changes in the money supply. The loanable funds market concept also ties back to earlier chapters on interest rates and investment.
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