MAcro CHAPTER 4.4:

CHAPTER SUMMARY

Most banks and governments around the world use a system called fractional reserve banking. This means that, when you deposit money in the bank as a customer, they only have to reserve (keep/hold onto) a fraction of that money, and they can loan out the rest.

How much can they loan out? That's decided by the Federal Reserve ("The Fed"), the central bank of the United States. They set the reserve requirement, which is the minimum percentage of deposits that banks have to hold in cash at all times. For example, if you put $100 in the bank, and the Fed has set a reserve requirement of 20%, then the bank only needs to hold $20 of that in cash (required reserves), and can loan out the other $80 of excess reserves (extra money) to other customers. They're basically assuming that not all the customers will come running to the bank at once asking for all their money, so they only need to hold a fraction of it at any one time.

This sets off a loop of loans and deposits that expands the money supply, the amount of money in the economy. Just like with spending and taxation, the fractional reserve system results in a multiplier effect. In this case, it's called the money multiplier, and the calculation is:

Money Multiplier = 1 / Reserve Requirement

This means that, if the reserve requirement is 20%, then new M0 introduced into the economy will be multiplied by 5 through the process of being repeatedly loaned out by banks (1 / 20% = 5). After the Fed introduced $100 of new M0, which is then deposited in a bank, the bank will loan out $80, which will get deposited in another account, which means that bank can now loan out $80 * 80% = $64, then 80% of that $64, etc. It is important to note that these deposits might happen at any bank - they might take a loan from Bank A, then pay it to a company that deposits it at Bank B - so this probably won't all happen at the same bank.

All this means that, if the Fed increases the reserve requirement from 20% to 50%, the money supply in the economy will fall drastically. Likewise, if the Fed lowers the reserve requirement from 20% to 10%, the money supply will rise.

Banks keep track of all this using a balance sheet. Balance sheets show all the assets (things owned by you or owed to you) and liabilities (things owed to others) of a company or bank. It is called a balance sheet because it has to "balance" - the assets must be equal to the liabilities. Customers' deposits in the bank are considered a liability, because the customer can ask for their money back any time. The cash the bank holds is an asset. So, if a customer deposits $1,000, the liabilities increase by $1,000 and the assets also increase by $1,000.

If the bank gives out a loan, that money is still owed to them, so there is no actual change in assets. As you can see, the only real change is that excess reserves become loans, but they stay in the same column - assets.

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