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Fractional Reserve Banking and the Money Creation Mechanism

Posted: Monday, 18 August, 2014. | By: Equipoise Bot

We all know that the Central Bank controls the money supply in a country, but how does it do so? Through the course of a simple exercise, we shall illustrate here how the banking system, through the fractional reserve system, creates money.

Though there are other factors at play, for simplicity’s sake we shall assume that only two instruments are at work through the course of this exercise: the required reserve ratio (RRR) and open market operations (OMOs). Let us define what the two are first.

The RRR is that fraction of deposits that any commercial bank must itself deposit with the central bank. This is a legally binding requirement, with penalties imposed on any bank that does not keep the minimum amount with the central bank. If the RRR is 20%, this means that if a bank has, say $100 million in deposits, it must keep at least $20 million with the central bank.

OMOs are operations of buying or selling government bonds that are conducted by the Central Bank to either inject or withdraw liquidity from the monetary system of the country. To withdraw liquidity, the Central Bank sells a government bond. Let’s say the bond is priced at $20 million. If this is the case, the buyer has to pay that amount to the Central Bank, and this money is then out of circulation. Similarly, if the Central Bank wishes to increase the amount of money in the system, they merely have to buy a government bond, injecting $20 million into the pockets of the country’s economy. OMOs are the most commonly used mechanism to control the money supply in the country.

Now let us work through an example to see the money creation process. 
Let us assume that the RRR is 20%. The Central Bank now buys a government security worth $100 million from a citizen A. This citizen now gets the $100 million and deposits it in his bank – let’s call this bank A. Bank A’s balance sheet now looks like this:

Assets
Cash=$100 m
 
Liabilities
Liabilities-$100 m

Deposit is a liability for the bank because the citizen can claim it anytime they want, and it owes the $100 million to the citizen. However, it is extremely unlikely that the citizen will want to withdraw all of the $100 m at once, so it does not need to keep all of it unutilised. The required reserve ratio is 20%, so only $20 m is required as deposits. The remaining $80 m can be loaned out to gain interest. So let us assume that the bank now lends out the remaining $80 m as a loan to individual B. The balance sheet now looks like this.

Assets
Cash=$100 m
Loans=$80 m

Liabilities
Liabilities-$100 m
Deposit is a liability for the bank because the citizen can claim it anytim

However, the story does not end here. B deposits the money in his own bank, making Bank B’s balance sheet look as follows:

Assets
Cash=$80 m
 
Liabilities
Liabilities-$80 m

Already we can see the money that has been created from the original $100 million is $180 million. This bank as well, sees that only .2*80=$16 million is required as reserves. The remaining $64 million can be loaned out to gain interest. The bank does this, getting the following balance sheet:

Assets
Cash=$16 m
Loans=$64 m 

Liabilities
Liabilities-$80 m

The loan is given to individual C, who deposits the money in her bank. That bank’s balance sheet now looks as follows:

Assets
Cash=$64m
 
Liabilities
Liabilities-$64 m

However, this bank also realises that only .2*64= $12.8 m is required as reserves and the remaining $51.2 can be used to gain interest through loans. The bank does this, creating the following balance sheet:

Assets
Cash=$12.8 m
Loans=$51.2 m

Liabilities
Liabilities-$64 m

This process goes on indefinitely. We can see that the total money being generated is an infinite GP, with CR = .8. Thus the total money generated is 100/(1-.8)= $500m.
By arguing in reverse, we can see the same effect when the Central Bank decides to sell a government bond worth $100 million.

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