Lesson preview · Banking Money Creation
Banks & Money Creation
~12 min · Free to read
You deposit 1000 dollars at your bank. The bank does not lock it in a vault. It keeps a small slice on hand and lends the rest — say 900 dollars — to someone buying a used car. Pause on what just happened. Your account still reads 1000 dollars. And the car seller now holds 900 dollars in cash. Two people each “have” money that started as a single 1000-dollar deposit.
Banks can do this because depositors almost never all want their cash back at once. On any given day, only a trickle of withdrawals comes in. So a bank safely keeps just a fraction of its deposits ready and puts the rest to work as loans. This is fractional-reserve banking: holding only a fraction of deposits as reserves and lending out the rest.
Key Term
Reserves and the reserve ratio
Two terms run through this whole lesson.
- Reserves — the money a bank keeps on hand (in its vault or parked at the central bank) instead of lending out. Reserves cover day-to-day withdrawals.
- Reserve ratio (also called the required reserve ratio) — the fraction of each deposit a bank keeps as reserves. If the reserve ratio is 10%, a bank holds 10 cents of every deposited dollar and lends the other 90.
A lower reserve ratio means a bank lends out more of each deposit. A higher reserve ratio means it keeps more and lends less.
Here is the part that surprises people. The 900 dollars the bank lent does not vanish. The car seller deposits it at their bank. That bank keeps its fraction — 90 dollars — and lends 810. The 810 gets spent, re-deposited, and lent again, minus another slice. Round after round, one fresh deposit ripples through the banking system, and each round adds new money. How much in total? A single ratio settles it.
The money multiplier. It says how many dollars of money one fresh dollar of reserves can ultimately support.
Notice the lever: the multiplier shrinks as the reserve ratio rises. At a 10% reserve ratio the multiplier is . At 20% it is . At 25% it is . The more each bank keeps back as reserves, the more leaks out of the lending chain each round, the sooner the cascade dies, and the less money gets created.
Tip
So what
That is money creation in one picture: the smaller the slice each bank keeps as reserves, the longer the lending cascade runs and the more total money one deposit creates.
Worked Example
You deposit 1000 dollars and the reserve ratio is 10%. (a) How much does your bank keep as reserves in the first round, and how much does it lend? (b) Find the money multiplier and the total new money the deposit can create. (c) How do the answers change if the reserve ratio rises to 20%?
Trap · Common Misconception
"Banks just lend out money they have sitting in a vault"
It is tempting to picture a bank as a warehouse that stores your cash until you want it back. But a bank keeps only a fraction on hand and lends the rest, and the act of lending is what creates new money — your deposit still reads 1000 while the borrower now holds 900.
This does not make everyone richer for free. Every dollar of new money is matched by a dollar of new debt: the borrower owes the loan back. The banking system multiplies the quantity of money in circulation, not society’s net wealth. This is also why bank-created money dwarfs physical cash — most of the money supply exists as deposits conjured by lending, not as printed notes.
Check yourself · no marks
A central bank injects 500 dollars of fresh reserves into the banking system. If the reserve ratio is 25%, what is the most new money this can create?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
If the reserve ratio is 10%, what is the money multiplier?
Next
Like what you read?
Sign up free to save your progress, get spaced reviews tuned to you, and unlock all 50 microeconomics knowledge points with interactive graphs and adaptive practice.