AP Macroeconomics
How Banks Create of Money
FRQ – 2011 #3; 2009 #3; 2009B
#2; 2006B #2
Banks can create money!
 When
you deposit money in a checking
account at the bank, does the bank
have to keep all your money in the bank
vault?
 The FED requires that banks keep only
a certain percentage of your money in
the bank vault or on deposit at the
FED.
Reserve Ratio (Requirement)

The percent that must be kept in the bank vault
or on deposit at the FED is the required reserve
ratio or reserve requirement.
 For example, if the RR is 20%, the bank must
keep $200 of your $1000 deposit in the bank
vault.
 What can the bank do with the other $800
(excess reserves)?
So – how do banks create $?
Bank
Deposit
RR
ER
Loan
A
$1000
$200
$800
$800
B
$800
$160
$640
$640
C
$640
$128
$512
$512
D
$512
$102.4
$409.6
$409.6
E
$409.6
…
…
…
F
…
…
…
…
…
…
…
…
…
Total Amount of $ created by banking system: $4000
Money Creation Formula

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A single bank can create $ by the amount of
its excess reserves.
The banking system as a whole can create $
by a multiple of the excess reserves.
MM X ER = Expansion of money
Money Multiplier = 1/RR
Ex. If RR = 20% MM = 1/.20 = 5
If $1000 is deposited in bank, required
reserves are $200; excess reserves are
$800.
The banking system as a whole can create:
5 X $800 = $4000.
New vs Existing $

If the initial deposit in a bank comes from the
FED or bank purchase of a bond or other
money out of circulation (buried treasure), the
deposit immediately increases the money
supply.
 The deposit then leads to further expansion of
the money supply through the money creation
process.
 Total change in MS if initial deposit is new $
= Deposit + $ created by banking system.
New vs. Existing $

If a deposit in a bank is existing $ (already
counted in M1; ex. Currency or checks),
depositing the amount does NOT change the
MS immediately because it is already
counted.
 Existing currency deposited into a checking
account changes only the composition of
the money supply from coins/paper $ to
checking account deposits.
 Total change in the MS if deposit is
existing $ = banking system created
money only.
Factors that weaken the
effectiveness of the deposit
multiplier:
 If
bank customers take their loans in cash
rather than in new checking account
deposits. (cash or currency drains)
 If banks fail to loan out all their excess
reserves.


https://www.youtube.com/watch?v=hcMXJmymZg0&list=PLD7C33A
B80B405B9A
Quiz practice
https://www.youtube.com/watch?v=6OpzAD9Okds&list=PLD7C33A
B80B405B9A