Multiple Deposit Creation and the Money Supply Process

http://www.ags.uci.edu/~pvanhorn/Deposit%20Creation.doc Recall that money supply = cash in circulation + bank deposits Bank deposits, not cash, account for the vast majority of the money supply. This is the case even though cash deposits, and cash reserves, are the foundation of the banking system. The reason why the volume of bank deposits is so much larger than the total amount of cash is that banks practice Fractional reserve banking is when cash is deposited into a bank, the bank keeps only a small fraction of that cash as reserves and loans the rest of it out, at interest. Fractional reserve banking is closely related to the phenomenon of multiple deposit creation: when cash is deposited into a bank, the bank loans out most of that money, and most of the money loaned gets redeposited into the banking system, and gets mostly loaned out again, and redeposited, and so on. The chain of deposit creation, or excess reserves (ER) being loaned out and redeposited in the banking system, continues until the banks have basically no more excess reserves. Multiple deposit creation can also be understood as follows: When the Fed creates an additional $1 in bank reserves, total bank deposits (and hence the money supply) increase by a multiple of that amount. The multiplication of an initial change in reserves into a much larger change in bank deposits occurs because of the chain of deposit creation, in which excess reserves are loaned out and redeposited ad infinitum. ...