<< Chapter < Page Chapter >> Page >

Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack’s Chevy Dealership as shown in [link] .

First national balance sheet

 The assets are reserves ($90,000) and loans ($8.1 million). The liabilities + net worth are deposits (+ $9 million).

If Jack’s deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as [link] shows.

Second national bank’s balance sheet

 The assets are reserves (+ $8.1 million). The liabilities + net worth are deposits (+ $8.1 million).

How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.

Watch this video to learn more about how banks create money.

The money multiplier and a multi-bank system

In a system with multiple banks, the initial excess reserve amount that Singleton Bank decided to lend to Hank’s Auto Supply was deposited into Frist National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, the amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks.

Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula    is:

1 Reserve Requirement

The money multiplier is then multiplied by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation.

Using the money multiplier formula

Using the money multiplier for the example in this text:

Step 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10.

Step 2. We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:

Total Change in the M1 Money Supply = 1 Reserve Requirement  ×  Excess Requirement = 1 0.10  ×  $9  million = 10  ×  $9  million = $90  million

Step 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.

Cautions about the money multiplier

The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.

Questions & Answers

how to print
Siti Reply
what is flow variable
Siyanda Reply
a flow is a quantity that can be measured over a specific period of time
Abhishek
is economics a social science or a pure science
Hilda Reply
social science
Sammy
social science
Babarali
social Science as a Subject and Pure science as a study
Abhishek
How to compute National income by using the expenditure approach
Bridget Reply
explain the method?
Sammy
hy
Sajjad
C+I+G+(X-M) C= Consumption Expenditure I= Investment Expenditure G= Government Expenditure X-M = Net Export
Abhishek
hw r u..?
Sharat
am good
lukimia
o nice
Sajjad
please I need a guardian on this topic
Albert
What do you need? Maybe we can help
Annisa
What's going on here?
Ivan
l need some information about macroeconomic
Sharat
First tell us what you already know about macroeconomic.
Ivan
any lecturer in here?
Albert
yes !! am here !! Lecturer of Economics And Statistics
Abhishek
Macroeconomics is too vast,so please be specific your question
niguse
Briefly explain whether the discipline of economics is a social science or pure science( normative or positive)
Okafor Reply
answer.... Economics is social science
Sammy
different between absolute advantage and comparative advantage
EDSON Reply
mathematical economics
masele Reply
show some questions under this topic
hassan
why met worth is added with libilitys in the balance sheet
bijoy Reply
what are the implications of inflation targeting?
Alinaitwe Reply
maximize profit
Murry
What happens to the goods and money market if the government cuts public spending?
Harman Reply
then the government will be punished by the public
soul
GDP, INFLATION, UNEMPLOYMENT & PRODUCTIVITY and then write a paragraph on the behavior of each variable after analyzing them graphically.
AWY
what is international trade
Stella Reply
International trade is the exchange of capital, goods, and services across international borders.
Bilal
international trade is the exchange of goods and services across boundaries
Zamu
international trade is the exchange of goods and services of country and abroad
Uwase
international is the process of exchanges of value interm of goods and services along national frontier
Murry
Trade*
Murry
Increase knowdge and skill. it save time and cost. Increase high Efficiency of production .
betta Reply
List kinds of Elastcity of Demand
betta
Is a faster rate of economic growth always a good thing as compared to a slower rate? And why?
LIMPHO Reply
what is unemployment
Doctor Reply
it is a situation during which workers remain jobless.
Zeeshan
is situation where people are willing to work but job are no available
Uwase
what is inflation
Sheila Reply
Inflation is a major concern to global economists, and it affects people from all walks of life. It refers to the measure or rate by which the cost of goods and services rises and purchasing power declines. As prices increase, monetary value decreases—prompting consumers to spend less on goods and s
King
inflation is the persistence rise in price level
Zamu
Inflation is the situation during which too much money is required to purchase too few goods.
Zeeshan
inflation is continuous increase in general price level
Uwase
it is the process where too much money pursuing fewer goods
Murry

Get the best Macroeconomics course in your pocket!





Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
Google Play and the Google Play logo are trademarks of Google Inc.

Notification Switch

Would you like to follow the 'Macroeconomics' conversation and receive update notifications?

Ask