HOW BANKS CREATE MONEY
After completing this chapter, students should be able to:
Recount the story of how fractional reserves began with goldsmiths.
Explain the effects of a currency deposit in a checking account on the composition and size of the
Compute a bank’s required and excess reserves when you are given its balance-sheet figures.
Explain why a commercial bank is required to maintain a reserve and why it isn’t sufficient to
Describe what happens to the money supply when a commercial bank makes a loan or buys
Describe what happens to the money supply when a loan is repaid or a bank sells its securities.
Explain what happens to a commercial bank’s reserves and demand deposits after it has made a
Describe how a check drawn on one commercial bank and deposited in another will affect the
reserves and excess reserves in each bank after the check clears.
Describe what would happen to a single bank’s reserves if it made loans that exceeded its excess
Explain how it is possible for the banking system to create an amount of money which is a
multiple of its excess reserves when no single bank ever creates money greater than its
Compute the size of the monetary multiplier and the money-creating potential of the banking
system when provided with appropriate data.
State the two leakages that reduce the money-creating potential of the banking system.
Define and identify the terms and concepts at the end of the chapter.
Although we are fascinated by large sums of currency, people use checkable
deposits called demand deposits or transaction accounts for most transactions.
Most transaction accounts are “created” as a result of bank loans.
This chapter compares money-creating abilities of a single commercial bank and the banking
system as a whole.
The term depository institution refers to banks and thrift institutions, but in this chapter the
term bank will be used generically to apply to all depository institutions.
Balance Sheet of a Single Bank
A balance sheet states the assets and claims of a bank at some point in time.
All balance sheets must balance, that is, the value of assets must equal value of claims.