Banking/Tutorials
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Money creation by fractional-reserve banking
Suppose, as an example, that banks are required to hold ten per cent of their deposits as reserve. Then suppose that someone with a thousand pounds/dollars at their disposal decides to deposit it in a current/checking account. The thousand pounds/dollars remains available, so putting it in the bank does not reduce the amount of money in the economy that is available for spending or investment.
Then - as shown in the table below - the bank adds the required £/$100 to its reserves and lends the remaining £/$900 to one of its customers, which adds that amount to the total of money that is available for spending or investment. In the second transaction shown in the table, that customer deposits it in a bank, and a repetition of the same sequence releases a further 810 into the money supply, transforming the initial 1000 from the previous 1900 to 2710 - and so on.
As the table shows, the amount added to the money supply diminishes with each transaction, suggesting that there is a limit to the total addition to the money supply that is possible. In fact the mathematics of series reveals what that limit is. The series: 1 + r + r2 + r3 + . . is a geometric series, and it can be shown that if r is less than 1, and if the series could be continued until it had an infinite number of terms, the total of all its terms would be 1/(1 - r).
In the example shown in the table, since the reserve ratio is assumed to be 10 per cent, every loan is for 90 per cent of the preceding deposit, and the appropriate value of r in the algebra column is therefore 0.9. The hypothetical bottom row shows the final amount of the addition to the money supply as 1,000 divided by one minus 0.9, which is 10,000. That amount could not be reached in reality, but it is approached more closely with every succeeding transaction.
Transaction Deposit Reserve Loan Available money Algebra 1000 P First 1000 100 900 1900 P+Pr Second 900 90 810 2710 P+Pr+Pr2 Third 810 81 729 3439 P+Pr+Pr2+Pr3 Infinite number 10,000 P/(1-r)