Principles of Macroeconomics / Unit 11 MAC 1022 review, 2 to 3 minutes
How Banks Create Money, and What Limits It
The idea
The claim that banks create money sounds like a trick and is not one, so it is worth assembling in order. A bank takes a deposit and holds part of it as reserves. It lends the rest by crediting a borrower's account, and that credited balance is itself a checkable deposit, which is money by the definition this unit started from. The borrower spends it, the payment lands at another bank as a fresh deposit, and that bank repeats the operation with a slightly smaller sum. No bank ever keeps what it created, which is why each one can honestly report that it created nothing, and the creation is nonetheless real because it happens in the system rather than in any one institution. Repayment runs the whole process backwards: a loan payment reduces a checkable deposit, so money is destroyed as loans are repaid.
In practice
Worked example, the ceiling and then the reality. At a 20 percent required ratio the multiplier is five, so a 2,000 cash deposit can support 10,000 in deposits and an 8,000 rise in the money supply once the cash that left circulation is subtracted. That is the ceiling, and three things keep the economy below it. Banks may hold excess reserves instead of lending, which they do most in a recession. Borrowers may not spend all of what they borrow. And anyone holding cash outside a bank breaks the chain at that point, because money in a pocket funds no further lending. Each leak shortens the chain, and the shortfall against the ceiling is the sum of them.
Where people slip
Three cautions. First, the required ratio the whole calculation rests on has been zero in the United States since March 2020, so the model is taught as the limited-reserves case the exam still asks for, not as a description of current policy; unit twelve gives the framework that replaced it. Second, with the ratio at zero the arithmetic of one divided by the ratio has no finite answer, and what actually limits lending is a bank's capital, its own judgement about risk and what the central bank pays it to hold reserves, which is again unit twelve. Third, the institution that makes fractional reserve banking survivable is deposit insurance, and it cuts both ways: guaranteeing deposits stops the run that would otherwise make a healthy bank fail, and it also reduces the reason for depositors to examine how carefully their bank lends. The witness states that plainly as a dilemma with no clean resolution, and the course leaves it that way.
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