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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

what is Pareto efficiency?
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Joseph Reply
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Oriho Reply
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Oriho
real costs are total money expenditure for the production of goods and services and opportunity costs is the money which is not included for production, like work of entrepreneurs in their own company
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Khan
What is foreign reserve? Why countries reserved? And have any limitations of this reserve?
Adil Reply
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Luyando Reply
endogenous and exogenous
Afzaal Reply
what is the difference between gdp and cpi?
Luyando
CPI is calculates the price change in goods and services purchased by the households whereas, GDP calculates the price change in goods and services purchased by all the consumers, government, businesses and foreigners.
Alice
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rusibana
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(1).Income is the main determined of macro economics. (a). true (b). false
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The
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tradeoff is a balance achieved between two desirable but conflicting things
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it may mean the stock available
DR
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Kgothatso
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Hannah Reply
A cost benefit analysis is a process by which organizations can analyze decisions, systems or projects, or determine a value for intangibles. The model is built by identifying the benefits of an action as well as the associated costs and subtracting the costs from benefits.
sanga
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Cost benefit analysis is a process used primarily by businesses that weighs the sum of the benefits, such as financial gain, of an action against the negatives, or costs, of that action.
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The next best option forgone is call the Opportunity cost of selection one.
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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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