a bank creates money when it: course hero

Learning Objectives

Utilize the money multiplier formulate to determine how banks create money

Money Creation by a Single Bank

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in [link]. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans.

The Money Multiplier and a Multi-Bank System

In a system with multiple banks, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank’s Auto Supply into First National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand.

Using the Money Multiplier Formula

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.

Cautions about the Money Multiplier

The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. 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.

Key Concepts and Summary

We define the money multiplier as the quantity of money that the banking system can generate from each $1 of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold as reserves.

Self-Check Questions

Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payments on loans) for a bank or other financial services company. Explain why you would be willing to pay more or less for a given loan if: