Jim Whitney Economics 101

 Fractional reserve banking

Example: A new deposit occurs at a bank (Bank 1)
    Percentage of
new desposit		 Proportion of
new deposit
(1) Required reserve ratio (RRR) =    
(2) Idle excess reserve ratio (IERR) =    
      Total reserve ratio (RR) =    
(3) Formula: New loan ratio (100% - RR) =    
    Percentage of
new loans		 Fraction of
new loans
(4) Assumption: All loan proceeds get re-deposited somewhere in the banking system, so the currency leakage ratio = 0% 0.00

    The banking system receives a new deposit of $100,000:
 

    New deposits 
(part of M1)		 New required reserves 
(RRR·new deposits)		 New idle excess reserves 
(IERR·new deposits)		 New loans Currency leakage
from banking system
1. Bank 1 100,000       $0
2. Bank 2         $0
3. Bank 3         $0
4. Bank 4         $0
  :
:		 :
:		 :
:		 :
:		 :
:		  
  Total         $0

    To do: Complete rows 1-4 of the table above.

    Note1: the deposit/lending process gradually dies down.
    Note2: Extra bank reserves give banks a powerful means for expanding credit.
    Note3: The economy's stock of money rises too, since all checking deposits count as part of M1.
 
    Technical note: the amount of money generated from each dollar of bank reserves is determined by the money multiplier.
    The size of the money multiplier = 1/(total reserve ratio)
        So, in total:
M1   =   currency   +   checking deposits
 =   currency   +   money multiplier x bank reserves
 =   currency   +   (1/(RR)) x bank reserves
 
For example, if the RRR = .15 and the IERR = .05:
    the reserve ratio =   .15 (required)   = .20, so the money multiplier is 1/.2 = 5.
 + .05 (excess) 
So each $1 change in bank reserves ultimately changes the money supply by $5.
In the example, bank reserves rise by $100,000, so the money supply rises by $500,000.
Of that total, $100,000 = the original deposit and $400,000 = new loans issued by banks.