MacroeconomicsI_working_version (1)

Money Market, Money Supply, Money Demand 67
A. Firstbank's Balance Sheet
Assets
Liabilities
Reserves $200 Deposits $1,000
Loans $800
C. Thirdbank's Balance Sheet
Assets
Liabilities
Reserves $128 Deposits $640
Loans $512
B. Secondbank's Balance Sheet
Assets
Liabilities
Reserves $160 Deposits $800
Loans $640
Figure 7.4 Balance Sheets Under Fractional-
Reserve Banking. This figure shows how $1,000 in
reserves leads to a much greater quantity of deposits.
Thus, under a fractional-reserve system, banks create
money.
Examining the impact on the money supply, we can see that Firstbank increases the supply
of money by $800 when it makes this loan. Initially the money supply was $1,000, which is
the total amount of deposits in Firstbank. This sum increased to $1,800 after the loan is
made. The money supply consists now of the depositor’s demand deposit of $1,000 and
$800 of currency holding by the borrower. Accordingly, under a system of fractionalreserve
banking, banks create money.
The money creation process does not stop with the Firstbank. The process continues as
long as the borrower pays to someone who deposits the $800 in another bank or the
borrower deposits the whole sum to a bank himself. Figure 7.4 shows also the balance sheet
of Secondbank. The sum of $800 obtained in deposit is divided into $160, (20 percent of
deposit, which must be kept in reserves) and $640, which could be used also as a loan.
Assume Thirdbank receiving this deposit, it holds 20percent, or $128, in reserve and
provides a loan of $512, and so on. Every additional deposit and loan create new money
and increase money supply.
By how much does the money supply increase? The process could evoke a false conviction
that the possible infinite amount of bank could produce an infinite amount of money.
Assuming reserve-deposit ratio as rr = 0,2 (20 percent in our example), the initial $1,000 of
deposit create following increase in money supply: