How Banks Create Money: Fractional Reserve Banking and the Money Multiplier

Banks create money by lending out most of the deposits they receive, and those loans become new deposits that get lent out again. Because banks keep only a fraction of deposits on hand as reserves and loan the rest, a single injection of money into the banking system can expand the total money supply by a large multiple. This is the core of fractional reserve banking, and it is one of the most tested ideas in AP Macroeconomics Unit 4.

The maximum expansion is set by the money multiplier, which equals 1 divided by the required reserve ratio. If banks must keep 10 percent of deposits in reserve, the multiplier is 10, so $1,000 of new reserves can support up to $10,000 in new deposits across the whole banking system. In the real world the expansion is smaller because of cash leakage and excess reserves, but the AP exam usually expects the clean textbook calculation unless it tells you otherwise.

What fractional reserve banking actually means

A bank does not lock your deposit in a vault and leave it there. It keeps a small slice as reserves and lends the rest out at interest. That is the whole business model, and it is why the system is called fractional reserve banking: only a fraction of deposits is held in reserve at any moment.

Reserves are the cash a bank holds plus the deposits it keeps at the Federal Reserve. Reserves split into two parts. Required reserves are the minimum the bank must legally hold, and excess reserves are anything above that minimum. Only excess reserves can be loaned out, and every new loan is where new money gets created.

The key AP insight is that money is more than physical currency. When a bank makes a loan, it credits the borrower's checking account, and checking deposits count as money (part of the M1 measure). No new bills were printed, yet the money supply grew. Lending literally creates new money in the form of new demand deposits.

The required reserve ratio and excess reserves

The required reserve ratio (RRR) is the fraction of checkable deposits a bank must hold as required reserves. It is set by the Federal Reserve. If the RRR is 0.10 (10 percent), a bank holding $1,000 in deposits must keep $100 as required reserves and may lend the other $900.

Three quantities show up in almost every problem, so keep them straight:

• Required reserves equal the RRR times total deposits.
• Excess reserves equal total reserves minus required reserves.
• Maximum new loans from a single bank equal its excess reserves.

Suppose a bank receives a fresh $1,000 cash deposit and the RRR is 10 percent. Required reserves rise by $100, and excess reserves rise by $900. That $900 is the maximum this one bank can lend out in the first round. Getting excess reserves right is usually the hardest step, so slow down there. You can check your arithmetic with the money multiplier calculator, which shows required reserves, excess reserves, and the total expansion for any RRR you enter.

Reading the T-account

A T-account is a simplified balance sheet shaped like the letter T. The left side lists assets (things the bank owns, such as reserves and loans) and the right side lists liabilities (things the bank owes, mainly the deposits it must return to customers). The two sides always balance.

Walk through the $1,000 deposit at a 10 percent RRR. When the customer deposits $1,000 in cash, the bank's assets rise by $1,000 in reserves, and its liabilities rise by $1,000 in demand deposits. The T-account balances. The bank then splits its reserves: $100 stays as required reserves and $900 becomes excess reserves available to lend.

Next the bank lends the $900. On the T-account, reserves fall by $900 and a new asset, loans, rises by $900. Assets still total the same, and liabilities are unchanged. When the borrower spends that $900 and the recipient deposits it in another bank, the process starts over at the next bank, which now must keep $90 in required reserves and can lend $810. Each round adds a smaller layer of new deposits.

The deposit expansion process

The chain of deposits, loans, and redeposits is the deposit expansion (or deposit multiplier) process. Trace the first few rounds with a 10 percent RRR and an initial $1,000 injection of new reserves:

Each row is 90 percent of the row above it because banks lend out 90 percent and hold 10 percent. The new loans form a shrinking series that sums to $9,000, and the total new deposits sum to $10,000. Notice the two different totals: the whole banking system creates $9,000 in brand new money through loans, but total deposits (including the original $1,000) grow to $10,000. Watch the wording of the AP question to know which number it wants.

You can watch this play out visually in the monetary policy sandbox, and the loanable funds sandbox shows how the extra lending pushes the real interest rate down.

The money multiplier formula

The money multiplier (also called the deposit multiplier or simple money multiplier) is the number that turns a change in reserves into the maximum change in the money supply. The formula is:

Money multiplier = 1 divided by the required reserve ratio.

With an RRR of 0.10, the multiplier is 1 / 0.10 = 10. To find the maximum change in the money supply, multiply the change in excess reserves by the money multiplier:

Maximum change in money supply = change in excess reserves times money multiplier.

This clean 1/RRR version is the simple deposit multiplier, the zero-leakage special case of the fuller money multiplier introduced later, in which no loan money is held as cash and banks hold no extra reserves. Two versions of the calculation appear on the exam, and mixing them up is a classic mistake. If new cash is deposited into a bank, only the excess reserves get multiplied. In our example, $900 in excess reserves times 10 equals $9,000 of new money created by loans, and total deposits reach $10,000. If instead the Fed injects reserves that are entirely excess (for example, buying $1,000 of bonds from a bank so the whole $1,000 is loanable), then $1,000 times 10 equals $10,000 of new money. Read carefully to decide whether the initial amount is all excess or split into required and excess.

A lower RRR means a bigger multiplier and more expansion; a higher RRR means a smaller multiplier and less expansion. That is why the reserve requirement is one of the three traditional monetary-policy tools taught in AP Macro, alongside open market operations and the discount rate. Note the real-world caveat: the Fed set the required reserve ratio to zero percent in March 2020 and now runs an ample-reserves system in which the reserve requirement is no longer used as an active tool (open market operations and administered rates do the work instead). For the AP exam it is still one of the three tools, but do not describe it as current Fed practice. For the full set of Unit 4 tools and how they shift aggregate demand, see the macro hub and the AD-AS sandbox.

Why the real-world multiplier is smaller

The 1/RRR formula gives the theoretical maximum. Actual money creation falls short of it for two reasons your AP course expects you to explain.

Cash leakage happens when people hold some of their loan as cash instead of redepositing all of it. Every dollar kept as currency drops out of the banking system, so it cannot be loaned again. This shrinks each round of the expansion and lowers the effective multiplier.

Excess reserves are the second leak. If banks choose to hold reserves above the required minimum (common when they are cautious or when loan demand is weak), they lend less than the model assumes. After the 2008 financial crisis, U.S. banks held enormous excess reserves, and the effective money multiplier collapsed toward a much smaller number than 10. Since the required reserve ratio went to zero in March 2020, the simple deposit-multiplier model no longer describes U.S. money creation at all, which is a useful reminder that 1/RRR is a teaching model rather than a live description of how the Fed operates. The simple formula quietly assumes zero excess reserves and zero cash leakage, which rarely holds in a real economy.

A more complete formula accounts for both leaks: the multiplier equals (1 + c) divided by (RRR + e + c), where c is the public's currency-to-deposit ratio and e is the excess-reserve ratio. Adding anything to the denominator makes the multiplier smaller, which is the whole point. You will not usually compute this on the AP exam, but you should be able to say in words why the real multiplier is lower than 1/RRR.

How this is tested on the AP exam

FRQs love to walk you through a T-account and then ask three things in a row: the required reserves on a deposit, the maximum amount a single bank can lend (its excess reserves), and the maximum change in the money supply for the whole banking system. Do them in that order and the numbers fall out cleanly.

• Single bank lends its excess reserves only, never the full deposit.
• The whole banking system multiplies excess reserves by 1/RRR.
• New money created by loans and total new deposits are different numbers, so answer the one asked.
• Explain leakages (cash held as currency, excess reserves) when asked why the real multiplier is smaller.

To lock it in, practice the graph-drawing steps at FRQ draw practice, walk through fully worked examples in graph walkthroughs, and drill mixed questions on the practice hub. Any unfamiliar term (M1, demand deposit, discount rate) is defined in the glossary. Master the T-account, the excess-reserve step, and the 1/RRR multiplier, and money creation becomes one of the most reliable points on the entire exam.