Question

How much money can Bank A create by making loans? How much money can the banking system as a whole create? Show your detailed calculation. What can you say about the relationship between the required reserve ratio and money creation? Why do some banks hold a part in excess reserves instead of loaning all excess reserves out? What are some other ways that banks may use a portion of their excess reserves?

Answer 1

Let, $100 be deposited in bank A and the reserve requirement be 10%.

Then, bank A has to keep $10 as reserve and loan out the remaining $90.

Now, if $90 is deposited in another bank, say, bank B.

Now, bank B has to keep $9 as reserve and loan out the remaining $81.

Again, if $81 is deposited in another bank, say, bank C.

Now, bank C has to keep $8.10 as reserve and loan out the remaining $72.9.

This process of money creation will go on.

Total money created = $100+$90+$81+$72.9+....

or, Total money created = $100(1+0.9+0.9²+0.9³+....)

or, Total money created = 100{1/(1-0.9)}

or, Total money created = $100*10

or, Total money created = $1000

Here, Money creation = Money deposited/Reserve ratio

Banks may keep a portion of their excess reserves as buffer i.e, to deal with any kinds of economic crisis.

Also, the banks may keep part of their excess reserves because its better than paying interest (Federal funds rate) on those reserves.