Friday, November 14, 2008

Fractional Reserve Banking: The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply

The Relationships Between the Monetary Base, the Reserve Ratio, and the Money Supply


The total amount of money in an economy depends on two things: the monetary base and the reserve ratio. The monetary base is the amount of currency in circulation or held as reserves. Reserves are the currency commercial banks hold in their vaults plus deposits in their accounts at the Fed.

The reserve ratio (R) is the fraction of deposits that banks hold as reserves. The reserve ratio (R) equals the required reserve ratio (rr) only if banks hold no excess reserves. The reserve ratio (R) is larger than the required reserve ratio (rr) when banks hold excess reserves.

The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is the reciprocal of the reserve ratio.


money multiplier = 1/R where R = reserve ratio


The money supply can be calculated as the monetary base multiplied by the money multiplier. If the reserve ratio is .10, for example, then the money multiplier is (1/.10) = 10. If the monetary base is $1 billion, then the money supply is $10 billion.

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