1. The United States has a fractional reserve banking system. This term means that banks only keep a part or a fraction of their checkable deposits backed by cash reserves.
2. The balance sheet of a single commercial bank is a statement of the assets, liabilities, and net worth (stock shares) of the bank at a specific time; and in the balance sheet, the bank’s assets equal its liabilities plus its net worth. This balance sheet changes with various transactions.
a. Transaction 1: Creating a bank. A commercial bank is founded by selling shares of stock and obtaining cash in return. Stock is a liability and cash is an asset.
b. Transaction 2: Acquiring property and equipment. A commercial bank needs property and equipment to carry on the banking business. They are assets of the bank.
c. Transaction 3: Accepting deposits. When a bank accepts deposits of cash, the cash becomes an asset to the bank, and checkable deposit accounts that are created are a liability. The deposit of cash in the bank does not affect the total money supply. It only changes its composition by substituting checkable deposits for currency (cash) in circulation.
d. Transaction 4: Depositing reserves in the Federal Reserve Bank.
(1) Three reserve concepts are vital to an understanding of the money-creating potential of a commercial bank.
(a) The required reserves, which a bank must maintain at its Federal Reserve Bank (or as vault cash at the bank) equal the reserve ratio multiplied by the checkable deposit liabilities of the commercial bank.
(b) The actual reserves of a commercial bank are its deposits at the Federal Reserve Bank (plus the vault cash).
(c) The excess reserves are equal to the actual reserves less the required reserves.
(2) The reserve ratio is the ratio of required reserves to a bank’s own checkable deposit liabilities. The Fed has the authority to establish and change the ratio within limits set by Congress.
e. Transaction 5: Clearing a check drawn against the bank. The writing of a check on the bank and its deposit in a second bank results in a loss of reserves (assets) and checkable deposits (liabilities) for the first bank and a gain in reserves and deposits for the second bank.
3. A single commercial bank in a multibank system can create money as the following two additional transactions show.
a. Transaction 6: Granting a loan. When a commercial bank grants a loan to a borrower, its balance sheet changes. Checkable deposit liabilities are increased by the amount of the loan and the loan value is entered as an asset. In essence, the borrower gives an IOU (a promise to repay the loan) to the bank, and in return the bank creates money by giving the borrower checkable deposits. The bank has “monetized” the IOU and created money. When the borrower writes a check for the amount of the loan to pay for something and that check clears, then the checkable deposits are reduced by the amount of that check. A bank lends its funds only in an amount equal to its pre-loan excess reserves because it fears the loss of reserves to other commercial banks in the economy.
b. Transaction 7: Buying government securities. When a bank buys government securities, it increases its own checkable deposit liabilities and therefore the supply of money by the amount of the securities purchase. The bank assets increase by the amount of the securities it now holds. The bank buys securities only in an amount equal to its excess reserves because it fears the loss of reserves to other commercial banks in the economy.
c. An individual commercial bank balances its desire for profits (which result from the making of loans and the purchase of securities) with its desire for liquidity or safety (which it achieves by having excess reserves or vault cash). The Federal funds market allows banks with excess reserves to lend funds overnight to banks that are short of required reserves. The interest rate paid on the overnight loans is the Federal funds rate.
4. The ability of a banking system composed of many individual commercial banks to lend and create money is a multiple (greater than 1) of its excess reserves and is equal to the excess reserves of the banking system multiplied by the checkable-deposit (of monetary) multiplier.
a. The banking system as a whole can do this even though no single commercial bank ever lends an amount greater than its excess reserves because the baking system, unlike a single commercial bank, does not lose reserves. If a bank receives a deposit of currency, it increases its checkable deposits. This change increases the amount of excess reserves the bank has available for loan. If a loan is made on these excess reserves, then it creates additional checkable deposits that, when spent, may be deposited in another bank. That other bank now has additional excess reserves and can increase its lending, and so the process continues.
b. The money multiplier is equal to the reciprocal of the required reserve ratio for checkable deposits. The maximum expansion of checkable deposits is equal to the initial excess reserves in the banking system multiplied by the monetary multiplier.
c. The money-creating process of the banking system can also be reversed. When loans are paid off, money is destroyed.
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