Saturday, November 15, 2008

Fractional Reserve Banking: Using T-accounts to Illustrate How Banks Create Money

Using T-accounts to Illustrate How Banks Create Money

Suppose the only currency in our simple economy is the 100 dollar-bills that Tracy deposited in the Dolphin Bank. If the required reserve ratio is .10 and all banks choose to hold no excess reserves, how large can the money supply become? If banks hold no excess reserves, then the reserve ratio is the same as the required reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Thus, this simple economy has a monetary base of $100. The money multiplier is 10 because it is the inverse of the reserve ratio (.10). Since the money supply is the monetary base multiplied by the money multiplier, the money supply in this economy is $1000.

To illustrate how a bank creates money, return to the previous example. Suppose a new bank, the Dolphin Bank, is created. Suppose the first depositor, Tracy, deposits 100 dollar bills in the Dolphin Bank and these are placed in the bank’s vault. At the end of this transaction, Tracy has a $100 deposit at the Dolphin Bank (which are liabilities for the bank) and the Dolphin Bank has $100 of reserves (cash in the vault, which are assets for the bank).

Table 9.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)


The Dolphin Bank will not earn any profit if it leaves the $100 in its vault. Banks earn profits by creating loans. Suppose the Dolphin Bank keeps $10 as required reserves and lends $90 to Brenda. It takes 90 dollar bills from the vault and gives them to Brenda as a loan. The Dolphin Bank now has $10 cash in the vault and its $90 loan to Brenda as assets.


Table 10.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 10
(cash in the bank’s vault)
Deposits $ 100
(owed to Tracy by the bank)
Loans $ 90
(owed to the bank by Brenda)



When people borrow money, they usually spend it. Suppose Brenda uses the $90 loan to buy a guitar from Carlos. Suppose Carlos deposits the $90 in an account at the Dolphin Bank. The bank now has $190 in deposits, $100 in vault cash, and $90 in loans.


Table 11.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 90
(owed to the bank by Brenda)



The Dolphin Bank now has excess reserves that can be used to create more loans. Since the bank is only required to keep $19 as reserves (10% of $190 is $19), it can create an $81 loan. Suppose the Dolphin Bank lends $81 to Jasmine.

Table 12.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 19
(cash in the bank’s vault)
Deposits $ 190
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Suppose Jasmine uses the $81 to buy a painting from Vincent. Suppose Vincent deposits the $81 in an account at the Dolphin Bank. The bank now has $271 is deposits, $100 in vault cash, and $171 in loans.


Table 13.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 171
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)



Once again, the Dolphin Bank has excess reserves that can be used to create additional loans. Since the bank is only required to keep $27.10 as reserves (10% of $271 is $27.10), it can create a $72.90 loan. Suppose the Dolphin Bank lends $72.90 to August.


Table 14.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 27.10
(cash in the bank’s vault)
Deposits $ 271
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)




Suppose August uses the $72.90 to buy a book from Maya. Suppose Maya deposits the $72.90 in an account at the Dolphin Bank. The bank now has $343.90 in deposits, $100 in vault cash, and $243.90 in loans.


Table 15.
Balance Sheet for the Dolphin Bank
ASSETS
LIABILITIES & NET WORTH
Reserves $ 100
(cash in the bank’s vault)
Deposits $ 343.90
($100 owed to Tracy by the bank)
($90 owed to Carlos by the bank)
($81 owed to Vincent by the bank)
($72.90 owed to Maya by the bank)
Loans $ 243.90
($90 owed to the bank by Brenda)
($81 owed to the bank by Jasmine)
($72.90 owed to the bank by August)



This process can continue until the entire $100 currency becomes required reserves. In this case, $1000 of deposits will have been created by issuing $900 in loans.


Table 16 provides an example of how $100 currency could create $1000 of money in the form of deposits in bank accounts if banks hold 10% of all deposits as reserves and create loans that equal 90% of the value of each deposit.

1 comment:

  1. So the trillion dollar question: if the bank eventually has all $100 in its vaults in order to meet its reserve requirements, how do the $900 in debts get paid back to the bank? From whence does the money come? The other trillion dollar question: what if everyone needs their money back from the bank at once?

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