Fractional Reserve Banking - and how money is “printed”
By allowing banks to loan out part of their deposits while also guaranteeing that all holders of notes can withdraw, the Federal Reserve creates new money. How this works:
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$100 is deposited in the bank
- customer maintains claim on entire $100
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bank can also lend out some amount of it, based on the reserve ratio. say they can loan out $90.
- so now there are two claims on the original $100. $100 from the customer, and $90 from the bank (or the lendee).
Thus, $90 has been added to the money supply.
Reserve ratio
This is set by the Fed. If the reserve ratio is 10%, banks can lend out the other 90%. 10% must be kept in reserve.
when a bank doesn’t have cash on hand for withdrawals, it can borrow from The Fed to satisfy.
Excess reserves can be deposited as Federal Funds.
money multiplier
Say there are $500 in deposits with a 10% reserve ratio - $50 - that means the bank can loan $450.
This $450 eventually makes its way back into the banking system as deposits.
Now the bank can loan 90% of that $450, or $405. etc. etc.
Eventually, the initial $500 deposit will turn into $5,000 in loans through this process.
formula for this:
Deposit Multiplier = 1 / Reserve Ratioat a 10% reserve ratio, would be 10x, because: 1 / 10% == 1 / (1/10) == 10.