How do banks create money?
Short answer: a bank keeps only a fraction of each deposit as reserves and lends the rest. The borrower spends the loan, and the money lands in someone else's bank account — where most of it is lent again. Round after round, the banking system as a whole turns one deposit into many. The total expansion equals the new reserves times the money multiplier, .
The mechanism in five steps
- You deposit 1,000 dollars in cash at Bank A. With a reserve ratio of 10 percent, the bank must keep 100 dollars as reserves and may lend the other 900.
- Bank A lends 900 dollars to a borrower, who spends it. The seller deposits that 900 dollars at Bank B. A brand-new deposit now exists that did not exist a moment ago.
- Bank B keeps 90 dollars (10 percent) and lends 810. That 810 is spent, redeposited at Bank C, which lends 729 — and so on, each round 10 percent smaller than the last.
- The deposits form a shrinking series: which sums to dollars of total deposits.
- The original 1,000 dollars was already money, so the new money created by lending is dollars — exactly the initial excess reserves (900) times the money multiplier (10).
Worked example
Suppose the reserve ratio is 20 percent and a customer deposits 5,000 dollars in cash.
Money multiplier:
Required reserves on the first deposit: dollars
Excess reserves available to lend: dollars
Maximum new money created: dollars
Maximum total deposits in the system: dollars
One 5,000-dollar deposit, when fully lent and relent, can support up to 25,000 dollars of deposits — 20,000 of which is money the system created out of its own lending.
Common misconception
“A single bank lends out a multiple of its deposits.” No — any one bank can only lend its excessreserves, never more than it holds. The multiple appears only across the whole system, because one bank's loan becomes the next bank's deposit. No single bank ever conjures ten dollars from one.
Frequently asked questions
- What is fractional-reserve banking?
- Fractional-reserve banking means a bank holds only a fraction of its deposits as reserves and lends out the rest. If the reserve ratio is 10 percent, a bank holds 10 cents of every deposited dollar and can lend 90 cents. Because the lent money comes back into the banking system as new deposits, the system creates far more money than was originally deposited.
- What is the reserve ratio?
- The reserve ratio is the share of deposits a bank must hold as reserves rather than lend out. It can be a legal requirement set by the central bank or a buffer the bank chooses to keep. A lower reserve ratio means each deposit supports more lending, so the money multiplier is larger.
- What is the money multiplier?
- The money multiplier is the maximum amount of money the banking system can create from one dollar of new reserves. It equals one divided by the reserve ratio. With a 10 percent reserve ratio, the multiplier is , so each dollar of excess reserves can support up to ten dollars of new deposits.
- Does a single bank create the full multiple of money?
- No. A single bank can only lend out its own excess reserves — it cannot lend a multiple of its deposits. The multiplication happens across the whole banking system, as the loan from one bank becomes a deposit at the next, which is partly lent again, and so on through many rounds.
- Why is the real-world money multiplier smaller than 1 divided by the reserve ratio?
- The simple formula assumes every dollar lent is fully redeposited and every bank lends all its excess reserves. In reality, people hold some cash rather than depositing it (a cash leakage), and banks often hold excess reserves rather than lending everything. Both reduce the actual expansion below the theoretical maximum.
- How does this connect to monetary policy?
- When the central bank buys bonds through open market operations, it adds reserves to the banking system. The money multiplier then amplifies those reserves into a larger change in the money supply. This is why a relatively small central-bank action can move the broad money supply by much more.
Learn the whole financial sector, not just the formula
Econ Academy's macroeconomics course walks through banking, the money market, and central-bank tools with interactive graphs and spaced repetition so the mechanics actually stick.