4.4 Banking and the Expansion of the Money Supply
Banks create money by lending excess reserves. In a limited-reserves system, maximum expansion = excess reserves x the money multiplier (1/rr).
Under fractional reserve banking, a bank keeps only a fraction of each deposit as reserves and lends the rest. On a T-account, a new deposit splits into required reserves (deposit × reserve ratio) and excess reserves, and only the excess reserves can be lent out.
Lending multiplies through the system: one bank's loan becomes another bank's deposit, which is split and re-lent again. The money multiplier caps the process at 1/(reserve ratio), so maximum new money created = initial excess reserves × multiplier. With a 10% reserve requirement, $900 of excess reserves supports up to $9,000 of new deposits.
The maximum assumes banks lend ALL excess reserves and borrowers redeposit everything (no cash leakage). Also mind what counts as new money: depositing $1,000 of currency doesn't change the money supply by itself, the cash just became a deposit, so at most $9,000 of NEW money is created, not $10,000.
Key terms for 4.4
Practice the math
Multiplying the entire deposit by the money multiplier. Maximum money creation starts from EXCESS reserves: a $1,000 cash deposit with rr = 10% creates at most $900 × 10 = $9,000 of new money, the original $1,000 was already money.
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