Question

Explain using a series of balance sheets how the Fed can increase the money supply in the economy.

Answer 1

Commercial bank creates money by creating loans and expanding deposits. When commercial bank gets deposit, it keep certain reserve with it and lends out rest of amount to potential borrowers. Further, when commercial bank lends out, it creates deposit of borrower. Now bank treats it as new deposits and keeping certain amount as reserve and lends out rest of money. In this way, commercial bank keeps on adding new deposits and lending out amount. Required reserve ratio decides level of money supply.

Following is example, suppose a bank gets 100 deposits, following shall be balance sheet:

Assets	Liabilities
Vault cash: 100	Checkable deposits: 100

Now suppose that reserve requirement is 10 %, then following shall be new Balance sheet:

Assets	Liabilities
Vault cash: 100 Loan = 90	Checkable deposits: 100 + 90

Now borrower new account is created, hence keeping 10 % reserve, rest of amount is lend out:

Now suppose customers withdraw money and deposit with another bank:

Assets	Liabilities
Vault cash: 90	Checkable deposits: 90

New Loan is created:

Assets	Liabilities
Vault cash: 90 Loan = 81	Checkable deposits: 90+81=171

Bank New Deposit New Required Reserve

New Loan First Local Bank

$100   0.1x100 =$10

100-10= $90

Second Local Bank $90

   0.1x90 = $9

90-9 =$81

Money created 1/r

Or 1/0.1

= 10 times

100*10

= 1,000

Total money supply 1,000