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                                                    Multiple Deposit Expansion

How the Money Supply Grows

Fractional Reserve Banking. In order for banks to earn profits, they hold only a fraction of the deposits and use the rest as loanable funds. The Federal Reserve requires that banks hold a minimum percentage of their deposits as reserves (say 10% or 20%) in order to have the cash on hand to meet the demand for withdrawals. This percentage set by the Fed is known as the required reserve ratio. Any reserves held by the bank above that amount required by the Fed is known as excess reserves.

Expanding the money supply. Assume that all banks are required to keep a fractional reserve of 10% of all deposits. The banks are free to lend out the remaining 90%. Also assume that this money loaned out is redeposit in another bank. Under these assumptions, if a new deposit of $1000 is made in Bank One, 10% or $100 is kept in reserve and the remaining $900 is loaned out. This $900 can be loaned to one person and he deposits it at National City Bank. National City is required to hold $90 as reserves and is able to loan out $810. The borrower in Society Bank deposits this loan of $810. Society Bank must keep 10% or $81 as reserves and loans out the remaining $729. This process can go on for a long time. In this example, the original deposit of $1,000 increased total bank reserves by $1,000. Eventually this led to an expansion of deposits to a total of $10,000; $1,000 of which was due to the original deposit, and $9,000 of which was due to bank lending activities. This total to original deposit expansion ratio of 10:1 was based on a fractional reserve of 10%. If the fractional reserve had been 15% of all deposits, instead of 10%, the amount of deposit expansion would have been less.