Role of banks in money creation

When commercial banks lend money, they expand the amount of bank deposits. The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.

Banks are limited in the total amount they can lend by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank.note The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than it initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

${\displaystyle \mathit{R}\mathit{R}\mathit{R}=\frac{R}{D}}$

where R are reserves and D are deposits.

In practice, if the central bank imposes a required reserve ratio (RRR) of 0.10, then each commercial bank is obliged to keep at least 10% of its total deposits as reserves, i.e. in the account it has at the central bank.

The process of money creation can be illustrated with the following United States example:

1. Corporation A deposits $100,000 into Bank of America.
2. Bank of America keeps $10,000 as reserves at the Federal Reserve (the central bank of the United States). To make a profit, Bank of America loans the remaining $90,000 to the federal government.
3. The government spends the $90,000 by buying something from corporation B.
4. B deposits the $90,000 into its account with Wells Fargo.
5. Wells Fargo keeps $9,000 as reserves at the Federal Reserve, and then lends the remaining $81,000 to the government.

If this chain continues indefinitely then, in the end, an amount approximating $1,000,000 has gone into circulation and has therefore become part of the total money supply. Furthermore, the Federal Reserve itself can and does lend money to banks as well as to the federal government.failed verification

There is currently neither an explanation on where the money comes from to pay the interest on all these loans,citation neededdubious – discuss nor is there an explanation as to how the United States Department of the Treasury manages default on said loans (see Lehman Brothers).citation neededdubious – discuss A negative supply of money is predicted to occur in the event that all loans are repaid at the same time.

The ratio of the total money added to the money supply (in this case, $1,000,000) to the total money added originally in the monetary base (in this case, $100,000) is the money multiplier.note In this context, the money multiplier relates changes in the monetary base,note which is the sum of bank reserves and issued currency, to changes in the money supply.

If changes in the monetary base cause a change in the money supply, then

${\displaystyle M_1=\mathit{M}\mathit{B}\cdot <!--\; \cdot \; -->m}$

where M₁ is the new money supply, MB is the monetary base, and m is the money multiplier. Therefore, the money multiplier is:

${\displaystyle m=\frac{M_1}{\mathit{M}\mathit{B}}\le <!--\; \le \; -->\frac{1}{\mathit{R}\mathit{R}\mathit{R}}}$

The central bank can control the money supply, according to this theory, by controlling the monetary base as long as the money multiplier is limited by the required reserve ratio.