Macroeconomics
A bank that wants to lend out more moneywouldkeepmoreexcessreserves.Thisreducesitsriskof becominginsolventwhenithastorepayitsliabilities(unabletomeetitslong-termdebts).Conversely, a bank that holds no excess reserves cannot make loansand is said to be fully loaned out . The Fractional-Reserve Banking System Fractional-reserve banking is the prevailing system in most economies. In this system, banks are requiredtohold onlyafractionofdepositsasreserves ,allowingthem tolendtheremainingfundsto borrowers .Thispracticeisbasedontheassumptionthatnotalldepositorswillsimultaneouslydemand their funds. It also allows banks to create new money through lending . In addition, this system assumesthatbanksloanoutalloftheirexcessreservesandthatallthemoneytakenoutasloans from one bank are deposited entirely .
Let’s examine how this system works through a numerical example.
Table 2: A Simple Demonstration of the Fractional-Reserve Banking System Banks’ Customers Required Reserves at rr = 10%
Excess Reserves Loaned Out
Individual A deposits $1,000
($1,000 × 0.1) = $100
($1,000 − $100) = $900 to individual B
Individual B deposits $900
$90
$810 to individual C
Individual C deposits $810 _ _ _ $729 to Individual D _ _ _ This process continues until there are no more reserves to be given out as loans and deposited into banks. $81 _ _ _
By loaning out from excess reserves, the bank has added to the economy’ money supply. However, bankscannotcreateunlimitedamountsofmoney.Whatdeterminesthelimitofhowmuchmoneyabank
can create? The money multiplier. The Simple Money Multiplier
The simplemoneymultiplier(MM) allowsustocalculatehowmuchthemoneysupply(MS)willchange when new money is introduced into the banking system (i.e., when the monetary base MB, which comprises currency in circulation and bank reserves, changes). 1 ( ) Using the money multiplier, we can calculate the maximum total change in money supply and the maximum increase in loans as follows: MM =
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