{"id":581,"date":"2015-05-07T20:49:57","date_gmt":"2015-05-07T20:49:57","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterymacro1xngcxmaster\/?post_type=chapter&#038;p=581"},"modified":"2018-06-19T23:33:12","modified_gmt":"2018-06-19T23:33:12","slug":"how-banks-create-money","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/oldwestbury-wm-macroeconomics\/chapter\/how-banks-create-money\/","title":{"raw":"How Banks Create Money","rendered":"How Banks Create Money"},"content":{"raw":"<div class=\"textbox learning-objectives\">\r\n<h3>Learning Objectives<\/h3>\r\n<ul>\r\n \t<li>Explain and show how banks create money<\/li>\r\n \t<li>Use the money multiplier formula to calculate how banks create money<\/li>\r\n<\/ul>\r\n<\/div>\r\n<h2>Money Creation by a Single Bank<\/h2>\r\nBanks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let\u2019s see how.\r\n\r\nStart 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 shown in Figure\u00a01. At this stage, Singleton Bank is simply storing money for depositors; it is not\u00a0using these deposits to make loans, so it cannot pay its depositors interest either.\r\n\r\n[caption id=\"attachment_4565\" align=\"aligncenter\" width=\"757\"]<img class=\"size-full wp-image-4565\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215018\/27_0051.jpg\" alt=\"The assets are reserves ($10 million). The liabilities + net worth are deposits ($10 million).\" width=\"757\" height=\"56\" \/> <strong>Figure 1.<\/strong> Singleton Bank\u2019s Balance Sheet: Receives $10 million in Deposits.[\/caption]\r\n\r\nSingleton Bank is required by the Federal Reserve to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.\r\n\r\nThis change in business plan alters Singleton Bank\u2019s balance sheet, as shown in Figure 2. Singleton\u2019s assets have changed; it now has $1 million in reserves and a loan to Hank\u2019s Auto Supply of $9 million. The bank still has $10 million in deposits.\r\n\r\n[caption id=\"attachment_4566\" align=\"aligncenter\" width=\"757\"]<img class=\"size-full wp-image-4566\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215250\/27_006.jpg\" alt=\"The assets are reserves ($1 million) and loan to hank\u2019s auto supply ($9 million). The liabilities + net worth are deposits ($10 million).\" width=\"757\" height=\"67\" \/> <strong>Figure 2.<\/strong> Singleton Bank\u2019s Balance Sheet: 10% Reserves, One Round of Loans[\/caption]\r\n\r\nSingleton Bank lends $9 million to Hank\u2019s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank\u2019s Auto Supply a cashier\u2019s check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 3 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest.\r\n\r\n[caption id=\"attachment_4568\" align=\"aligncenter\" width=\"757\"]<img class=\"size-full wp-image-4568\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215514\/27_0071.jpg\" alt=\"The assets are reserves (+ $9 million). The liabilities + net worth are deposits (+ $9 million).\" width=\"757\" height=\"56\" \/> <strong>Figure 3.<\/strong> First National\u00a0Bank's Balance Sheet: Required 10% Reserves[\/caption]\r\n\r\nMaking loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which can be easily used as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously these deposits will be drawn down as Hank\u2019s Auto Supply writes checks to pay its bills. But the bigger picture is that a bank must hold enough money in reserves to meet its liabilities; the rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million.\r\n\r\nNow, First National must hold only 10% as required reserves ($90,000) but can lend out the other 90% ($8.1 million) in a loan to Jack\u2019s Chevy Dealership as shown in Figure 4.\r\n\r\n[caption id=\"attachment_4569\" align=\"aligncenter\" width=\"757\"]<img class=\"size-full wp-image-4569\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215612\/27_008.jpg\" alt=\"The assets are reserves ($90,000) and loans ($8.1 million). The liabilities + net worth are deposits (+ $9 million).\" width=\"757\" height=\"67\" \/> <strong>Figure 4<\/strong>. First National Balance Sheet[\/caption]\r\n\r\nIf Jack\u2019s deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 5 shows.\r\n\r\n[caption id=\"attachment_4570\" align=\"aligncenter\" width=\"757\"]<img class=\"size-full wp-image-4570\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215720\/27_009.jpg\" alt=\"The assets are reserves (+ $8.1 million). The liabilities + net worth are deposits (+ $8.1 million).\" width=\"757\" height=\"56\" \/> <strong>Figure 5<\/strong>. Second National Bank\u2019s Balance Sheet[\/caption]\r\n\r\nHow is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7616\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7617\r\n\r\n<\/div>\r\n<div class=\"textbox examples\">\r\n<h3>Watch It<\/h3>\r\nThis video explains how banks use deposits and loans to create money.\r\n<script type=\"text\/javascript\" src=\"\/\/static.3playmedia.com\/p\/projects\/20361\/files\/2587548\/plugins\/11085.js\"><\/script><script src=\"https:\/\/www.youtube.com\/iframe_api\" type=\"text\/javascript\"><\/script>\r\n<iframe id=\"myytplayer\" src=\"https:\/\/www.youtube.com\/embed\/JG5c8nhR3LE?enablejsapi=1\" width=\"800\" height=\"470\" frameborder=\"0\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe>\r\n\r\n<\/div>\r\n<h2 class=\"entry-title\">The Money Multiplier in a Multi-Bank System<\/h2>\r\nIn a system with multiple banks, the initial excess reserve amount that Singleton Bank decided to lend to Hank\u2019s Auto Supply was deposited 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.\u00a0In a multi-bank system, the amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be \u201cmultiplied\u201d as it is spent in the economy and then re-deposited in other banks.\r\n\r\nFortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The\u00a0<strong>money multiplier formula<\/strong>\u00a0is:\r\n<p style=\"text-align: center;\">[latex]\\displaystyle\\frac{1}{\\text{Required Reserve Ratio}}[\/latex]<\/p>\r\nThe money multiplier is then multiplied by the change in excess reserves to determine the total amount of M1 money supply created in the banking system.\r\n<div class=\"textbox exercises\">\r\n<h3>USING THE MONEY MULTIPLIER FORMULA<\/h3>\r\nUsing the money multiplier for the example from Singleton Bank above in this text:\r\n\r\n<strong>Step 1.<\/strong> 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.\r\n\r\n<strong>Step 2.<\/strong> We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:\r\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=\\frac{1}{\\text{Required Reserve Ratio}}\\times\\text{Excess Requirement}[\/latex]<\/p>\r\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=\\frac{1}{0.10}\\times{9}\\text{ million}[\/latex]<\/p>\r\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=10\\times{9}\\text{ million}[\/latex]<\/p>\r\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=90\\text{ million}[\/latex]<\/p>\r\n<strong>Step 3.<\/strong> Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.\r\n\r\n<\/div>\r\n<h2 id=\"m48767-fs-idp9084608\">Cautions about the Money Multiplier<\/h2>\r\nThe money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. 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. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as we will discuss in more depth in the module on monetary policy.\r\n\r\nThe process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out, again, and again.\r\n\r\nFinally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as \u201cmattress savings,\u201d or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7618\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7619\r\n\r\n<\/div>\r\n<div class=\"textbox examples\">\r\n<h3>Watch it<\/h3>\r\nThis video explains how money is created and reviews the concepts you just learned about the money multiplier. It also explains a little bit about the Federal Reserve's involvement in creating new money to buy financial assets, thereby adding reserves to the banking system.\r\n\r\nIf banks hold the minimum amount of money required by the reserve ratio, then they would lend out 90% of their reserves, and the multiplier would continue to stay around 10. This does not happen in practice, and the multiplier remains closer to 3. When we talk about monetary policy in more depth later, you'll learn more about other ways that the Federal Reserve may choose to increase the money supply.\r\n\r\n<iframe src=\"https:\/\/www.youtube.com\/embed\/93_Va7I7Lgg?rel=0\" width=\"800\" height=\"470\" frameborder=\"0\" data-mce-fragment=\"1\"><\/iframe>\r\n\r\n<\/div>\r\n<div class=\"textbox tryit\">\r\n<h3>Try It<\/h3>\r\nThese questions allow you to get as much practice as you need, as you can click the link at the top of the first question (\u201cTry another version of these questions\u201d) to get a new set of questions. Practice until you feel comfortable doing the questions.\r\n\r\n[ohm_question]153725-153726-153741[\/ohm_question]\r\n\r\n<\/div>\r\n<div class=\"textbox learning-objectives\">\r\n<h3>Glossary<\/h3>\r\n[glossary-page][glossary-term]money multiplier: [\/glossary-term]\r\n[glossary-definition]ratio of total money in the economy divided by the amount of reserves, or the ratio of change in the total money in the economy divided by a change in the amount of reserves; formula for the money multiplier is 1\/(required reserve ratio)[\/glossary-definition][glossary-term]required reserve ratio:[\/glossary-term]\r\n[glossary-definition]percentage of total deposits a bank must hold as reserves[\/glossary-definition][\/glossary-page]\r\n\r\n<\/div>","rendered":"<div class=\"textbox learning-objectives\">\n<h3>Learning Objectives<\/h3>\n<ul>\n<li>Explain and show how banks create money<\/li>\n<li>Use the money multiplier formula to calculate how banks create money<\/li>\n<\/ul>\n<\/div>\n<h2>Money Creation by a Single Bank<\/h2>\n<p>Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let\u2019s see how.<\/p>\n<p>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 shown in Figure\u00a01. At this stage, Singleton Bank is simply storing money for depositors; it is not\u00a0using these deposits to make loans, so it cannot pay its depositors interest either.<\/p>\n<div id=\"attachment_4565\" style=\"width: 767px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-4565\" class=\"size-full wp-image-4565\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215018\/27_0051.jpg\" alt=\"The assets are reserves ($10 million). The liabilities + net worth are deposits ($10 million).\" width=\"757\" height=\"56\" \/><\/p>\n<p id=\"caption-attachment-4565\" class=\"wp-caption-text\"><strong>Figure 1.<\/strong> Singleton Bank\u2019s Balance Sheet: Receives $10 million in Deposits.<\/p>\n<\/div>\n<p>Singleton Bank is required by the Federal Reserve to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.<\/p>\n<p>This change in business plan alters Singleton Bank\u2019s balance sheet, as shown in Figure 2. Singleton\u2019s assets have changed; it now has $1 million in reserves and a loan to Hank\u2019s Auto Supply of $9 million. The bank still has $10 million in deposits.<\/p>\n<div id=\"attachment_4566\" style=\"width: 767px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-4566\" class=\"size-full wp-image-4566\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215250\/27_006.jpg\" alt=\"The assets are reserves ($1 million) and loan to hank\u2019s auto supply ($9 million). The liabilities + net worth are deposits ($10 million).\" width=\"757\" height=\"67\" \/><\/p>\n<p id=\"caption-attachment-4566\" class=\"wp-caption-text\"><strong>Figure 2.<\/strong> Singleton Bank\u2019s Balance Sheet: 10% Reserves, One Round of Loans<\/p>\n<\/div>\n<p>Singleton Bank lends $9 million to Hank\u2019s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank\u2019s Auto Supply a cashier\u2019s check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 3 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest.<\/p>\n<div id=\"attachment_4568\" style=\"width: 767px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-4568\" class=\"size-full wp-image-4568\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215514\/27_0071.jpg\" alt=\"The assets are reserves (+ $9 million). The liabilities + net worth are deposits (+ $9 million).\" width=\"757\" height=\"56\" \/><\/p>\n<p id=\"caption-attachment-4568\" class=\"wp-caption-text\"><strong>Figure 3.<\/strong> First National\u00a0Bank&#8217;s Balance Sheet: Required 10% Reserves<\/p>\n<\/div>\n<p>Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which can be easily used as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously these deposits will be drawn down as Hank\u2019s Auto Supply writes checks to pay its bills. But the bigger picture is that a bank must hold enough money in reserves to meet its liabilities; the rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million.<\/p>\n<p>Now, First National must hold only 10% as required reserves ($90,000) but can lend out the other 90% ($8.1 million) in a loan to Jack\u2019s Chevy Dealership as shown in Figure 4.<\/p>\n<div id=\"attachment_4569\" style=\"width: 767px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-4569\" class=\"size-full wp-image-4569\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215612\/27_008.jpg\" alt=\"The assets are reserves ($90,000) and loans ($8.1 million). The liabilities + net worth are deposits (+ $9 million).\" width=\"757\" height=\"67\" \/><\/p>\n<p id=\"caption-attachment-4569\" class=\"wp-caption-text\"><strong>Figure 4<\/strong>. First National Balance Sheet<\/p>\n<\/div>\n<p>If Jack\u2019s deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 5 shows.<\/p>\n<div id=\"attachment_4570\" style=\"width: 767px\" class=\"wp-caption aligncenter\"><img loading=\"lazy\" decoding=\"async\" aria-describedby=\"caption-attachment-4570\" class=\"size-full wp-image-4570\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images-archive-read-only\/wp-content\/uploads\/sites\/1294\/2016\/07\/11215720\/27_009.jpg\" alt=\"The assets are reserves (+ $8.1 million). The liabilities + net worth are deposits (+ $8.1 million).\" width=\"757\" height=\"56\" \/><\/p>\n<p id=\"caption-attachment-4570\" class=\"wp-caption-text\"><strong>Figure 5<\/strong>. Second National Bank\u2019s Balance Sheet<\/p>\n<\/div>\n<p>How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.<\/p>\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>\t<iframe id=\"lumen_assessment_7616\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7616&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7616\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><br \/>\n\t<iframe id=\"lumen_assessment_7617\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7617&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7617\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><\/p>\n<\/div>\n<div class=\"textbox examples\">\n<h3>Watch It<\/h3>\n<p>This video explains how banks use deposits and loans to create money.<br \/>\n<script type=\"text\/javascript\" src=\"\/\/static.3playmedia.com\/p\/projects\/20361\/files\/2587548\/plugins\/11085.js\"><\/script><script src=\"https:\/\/www.youtube.com\/iframe_api\" type=\"text\/javascript\"><\/script><br \/>\n<iframe loading=\"lazy\" id=\"myytplayer\" src=\"https:\/\/www.youtube.com\/embed\/JG5c8nhR3LE?enablejsapi=1\" width=\"800\" height=\"470\" frameborder=\"0\"><span data-mce-type=\"bookmark\" style=\"display: inline-block; width: 0px; overflow: hidden; line-height: 0;\" class=\"mce_SELRES_start\">\ufeff<\/span><\/iframe><\/p>\n<\/div>\n<h2 class=\"entry-title\">The Money Multiplier in a Multi-Bank System<\/h2>\n<p>In a system with multiple banks, the initial excess reserve amount that Singleton Bank decided to lend to Hank\u2019s Auto Supply was deposited 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.\u00a0In a multi-bank system, the amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be \u201cmultiplied\u201d as it is spent in the economy and then re-deposited in other banks.<\/p>\n<p>Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The\u00a0<strong>money multiplier formula<\/strong>\u00a0is:<\/p>\n<p style=\"text-align: center;\">[latex]\\displaystyle\\frac{1}{\\text{Required Reserve Ratio}}[\/latex]<\/p>\n<p>The money multiplier is then multiplied by the change in excess reserves to determine the total amount of M1 money supply created in the banking system.<\/p>\n<div class=\"textbox exercises\">\n<h3>USING THE MONEY MULTIPLIER FORMULA<\/h3>\n<p>Using the money multiplier for the example from Singleton Bank above in this text:<\/p>\n<p><strong>Step 1.<\/strong> 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.<\/p>\n<p><strong>Step 2.<\/strong> We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:<\/p>\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=\\frac{1}{\\text{Required Reserve Ratio}}\\times\\text{Excess Requirement}[\/latex]<\/p>\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=\\frac{1}{0.10}\\times{9}\\text{ million}[\/latex]<\/p>\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=10\\times{9}\\text{ million}[\/latex]<\/p>\n<p style=\"text-align: center;\">[latex]\\displaystyle\\text{Total change in the M1 Money Supply}=90\\text{ million}[\/latex]<\/p>\n<p><strong>Step 3.<\/strong> Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.<\/p>\n<\/div>\n<h2 id=\"m48767-fs-idp9084608\">Cautions about the Money Multiplier<\/h2>\n<p>The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. 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. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as we will discuss in more depth in the module on monetary policy.<\/p>\n<p>The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out, again, and again.<\/p>\n<p>Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as \u201cmattress savings,\u201d or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.<\/p>\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>\t<iframe id=\"lumen_assessment_7618\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7618&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7618\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><br \/>\n\t<iframe id=\"lumen_assessment_7619\" class=\"resizable\" src=\"https:\/\/assessments.lumenlearning.com\/assessments\/load?assessment_id=7619&#38;embed=1&#38;external_user_id=&#38;external_context_id=&#38;iframe_resize_id=lumen_assessment_7619\" frameborder=\"0\" style=\"border:none;width:100%;height:100%;min-height:400px;\"><br \/>\n\t<\/iframe><\/p>\n<\/div>\n<div class=\"textbox examples\">\n<h3>Watch it<\/h3>\n<p>This video explains how money is created and reviews the concepts you just learned about the money multiplier. It also explains a little bit about the Federal Reserve&#8217;s involvement in creating new money to buy financial assets, thereby adding reserves to the banking system.<\/p>\n<p>If banks hold the minimum amount of money required by the reserve ratio, then they would lend out 90% of their reserves, and the multiplier would continue to stay around 10. This does not happen in practice, and the multiplier remains closer to 3. When we talk about monetary policy in more depth later, you&#8217;ll learn more about other ways that the Federal Reserve may choose to increase the money supply.<\/p>\n<p><iframe loading=\"lazy\" src=\"https:\/\/www.youtube.com\/embed\/93_Va7I7Lgg?rel=0\" width=\"800\" height=\"470\" frameborder=\"0\" data-mce-fragment=\"1\"><\/iframe><\/p>\n<\/div>\n<div class=\"textbox tryit\">\n<h3>Try It<\/h3>\n<p>These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (\u201cTry another version of these questions\u201d) to get a new set of questions. Practice until you feel comfortable doing the questions.<\/p>\n<p><iframe loading=\"lazy\" id=\"ohm153725\" class=\"resizable\" src=\"https:\/\/ohm.lumenlearning.com\/multiembedq.php?id=153725-153726-153741&theme=oea&iframe_resize_id=ohm153725&show_question_numbers\" width=\"100%\" height=\"150\"><\/iframe><\/p>\n<\/div>\n<div class=\"textbox learning-objectives\">\n<h3>Glossary<\/h3>\n<div class=\"titlepage\">\n<dl>\n<dt>money multiplier: <\/dt>\n<dd>ratio of total money in the economy divided by the amount of reserves, or the ratio of change in the total money in the economy divided by a change in the amount of reserves; formula for the money multiplier is 1\/(required reserve ratio)<\/dd>\n<dt>required reserve ratio:<\/dt>\n<dd>percentage of total deposits a bank must hold as reserves<\/dd>\n<\/dl>\n<\/div>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-581\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Original<\/div><ul class=\"citation-list\"><li>Modification, adaptation, and original content. <strong>Provided by<\/strong>: Lumen Learning. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em><\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Shared previously<\/div><ul class=\"citation-list\"><li>How Banks Create Money. <strong>Provided by<\/strong>: OpenStax College. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:hB_WPDrK@5\/How-Banks-Create-Money\">https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:hB_WPDrK@5\/How-Banks-Create-Money<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em>. <strong>License Terms<\/strong>: Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.44<\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">All rights reserved content<\/div><ul class=\"citation-list\"><li>How Banks Create Money. <strong>Provided by<\/strong>: ACDC Leadership. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/www.youtube.com\/watch?v=JG5c8nhR3LE&#038;index=12&#038;list=PLD7C33AB80B405B9A\">https:\/\/www.youtube.com\/watch?v=JG5c8nhR3LE&#038;index=12&#038;list=PLD7C33AB80B405B9A<\/a>. <strong>License<\/strong>: <em>Other<\/em>. <strong>License Terms<\/strong>: Standard YouTube License<\/li><li>The Money Multiplier. <strong>Provided by<\/strong>: Marginal Revolution University. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/www.youtube.com\/watch?v=93_Va7I7Lgg&#038;t=180s\">https:\/\/www.youtube.com\/watch?v=93_Va7I7Lgg&#038;t=180s<\/a>. <strong>License<\/strong>: <em>Other<\/em>. <strong>License Terms<\/strong>: Standard YouTube License<\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section>","protected":false},"author":74,"menu_order":16,"template":"","meta":{"_candela_citation":"[{\"type\":\"cc\",\"description\":\"How Banks Create Money\",\"author\":\"\",\"organization\":\"OpenStax College\",\"url\":\"https:\/\/cnx.org\/contents\/vEmOH-_p@4.44:hB_WPDrK@5\/How-Banks-Create-Money\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"Download for free at http:\/\/cnx.org\/contents\/bc498e1f-efe9-43a0-8dea-d3569ad09a82@4.44\"},{\"type\":\"copyrighted_video\",\"description\":\"How Banks Create Money\",\"author\":\"\",\"organization\":\"ACDC 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