Money, Banking, and Monetary Policy ❮ 149Eli decides, just to be safe, to hold a small percentage of his total deposits in the vault
to cover any daily withdrawals, and earn some interest income by lending out the rest to
households or small businesses. He even realizes that he must offer a small rate of interest
to his depositors to compensate them for that “whole time value of money thing.” The
fraction of total deposits kept on reserve is called the reserve ratio. Each time he receives a
deposit, he puts that fraction in the vault and lends the rest. This process is the foundation
for money creation and the Fed’s ability to conduct monetary policy.Money Creation
A specific example of how the fractional reserve system can multiply one new bank deposit
into new created money illustrates the process of money creation.
The reserve ratio is 10 percent. In other words,
Reserve ratio (rr) = Cash reserves/Total deposits = 0.10
One way to see how checking deposits turn into loans and how loans turn into new
money is to create a basic T-account, or balance sheet. The idea of a balance sheet is to show
the assets and liabilities of a bank. In our example, total assets must equal total liabilities.
Asset. Anything owned by the bank or owed to the bank is an asset of the bank. Cash
on reserve is an asset, and so are loans made to citizens.
Liability. Anything owned by depositors or lenders to the bank is a liability. Checking
deposits of citizens or loans made to the bank are liabilities to the bank.
Let’s look at an example:
Step 1. Katie takes $1,000 from under her mattress, deposits it at ECB, and opens a
checking account. If the Federal Reserve, the central bank of the United States, tells the
ECB that it must hold 10 percent of all deposits in reserve, then the ECB must comply and
keep no less than $100 of Katie’s deposit as “required” reserves. The remaining $900 of the
deposit are excess reserves and can be kept on reserve in the bank or lent to another person.KEY IDEA
Balance Sheet ECB (Step 1)
ASSETS LIABILITIES
Required Reserves $ 100 Checking Deposits $1,000
Excess Reserves $ 900
Total Assets $ 1,000 Total Liabilities $1,000Balance Sheet ECB (Step 2)
ASSETS LIABILITIES
Required Reserves $ ,1, 100 Checking Deposits $1,000
Excess Reserves $ 1,90 0
Loans $ 1, 900
Total Assets $ 1,900 Total Liabilities $1,000It is important to understand that Katie’s deposit is not initially creating an increase in
the money supply. When she takes $1,000 of cash and puts it into a checking account, the
quantity of money in M1 remains the same. What happens next will eventually create an
increase in the money supply.
Step 2. ECB lends all $900 in excess reserves to Theo, a local farmer.TIP