4.4 — Banking and the Expansion of the Money Supply

There are two sections to a bank balance sheet: assets and liabilities. The cumulative sum of all assets is always equal to the cumulative sum of all liabilities.

Liabilities

A bank’s balance sheet has the following liabilities:

• Demand Deposits
  • Also known as checkable deposits and checking account deposits
  • If someone deposits money into their checking account, the demand deposit liability increases as the bank now owes this money back to the person. Conversely, if they withdraw money from their account, the liability increases
  • There is a federal reserve-mandated reserve requirement which defines the proportion of demand deposits that banks cannot loan out. This is represented by Required Reserves in the Assets section of the bank balance sheet
• Saving Deposits
  • Represents money that customers have deposited into their savings account: increases when customers deposit more money
  • There is no reserve requirement for saving deposits
• Other Liabilities
  • Profit or owner equity, bank debt, etc
  • A bank taking on more debt will increase liabilities

Assets

A bank’s balance sheet has the following assets:

• Required Reserves
  • The percentage of demand deposits that are set by the federal reserves
  • This is money that the bank cannot loan out
• Excess Reserves
  • The remaining amount of total reserves that the bank can loan out
  • This is all remaining reserve assets that are not required to be withheld
• Loans
  • This represents money that the bank has loaned out to its customers
• Other Assets
  • This represents other assets like bonds, physical assets, buildings, desks, chairs, etc

Money Multiplier

Since bank processes are cyclical (someone deposits money, which is later loaned out by someone else, which is then deposited by someone else, and so on), it leads to a money multiplier effect similar to what we saw in 3.2 — The Multiplier Effect. Essentially, the money multiplier refers to how many dollars worth of new loans, deposits, and money can be created from a banks’ excess reserves. The formula for the money multiplier is: $\text{Money Multiplier}=\frac{1}{\text{Reserve Requirement}}$ If we take the money multiplier and multiply it by the bank’s excess reserves, we find the amount of new money, loans, and deposits that can be made through those excess reserves (based on the current federal reserve requirement).

When money is deposited into a bank, we can use the money multiplier to find the maximum amount of deposits, loans, and money that can be generated:

• $\text{New Loans}=\text{Excess Reserves}\times \text{Money Multiplier}$
• $\text{New Money}=\text{Excess Reserves}\times \text{Money Multiplier}$
• $\text{New Deposits}=\text{Excess Reserves}\times \text{Money Multiplier}+\text{Initial Deposit}$

However, when we’re dealing with Open Market Operations, which is when the we’re dealing with bonds, remember that bonds are not considered as initial deposits so their sale will mean there is more new money.

• $\text{New Money}=\text{Excess Reserves}\times \text{Money Multiplier}+\text{Bonds That Became Money}$