The Banking System and the Money Multiplier

In earlier sections of this course we looked at the critical role that business investment plays in facilitating economic growth. The conclusion was made that additions to the capital stock (investment), in the form of machinery and equipment that assist workers in the production process are the key catalyst for future economic growth. As worker productivity rises, so do output and national income. The essence of economic systems that rely on capital as the engine of economic growth is the monetary and financial system. Well-operating financial systems facilitate the investment process by making savings readily available for businesses to borrow and invest in new capital.

Central Banking

The Role of Money

What constitutes money? Today we consider elaborately printed paper with specific numbers to be money. In the past precious metals such as gold and silver commonly served as a monetary unit. In order to be considered money, a commodity (such as gold) or paper (fiat money) that represents some tangible value must be accepted by the public. Whatever is considered money must serve several purposes:

Measures of Money

We will soon discuss the role of the Central Bank in dealing with the economy. Central Banks impact the economy through the money supply. In the United States there are several measures of the money supply that the Federal Reserve Board can adjust when using active monetary policy. The two most important definitions of money are known as M1 and M2.

M1 is the narrowest definition of money and includes

  1. currency and coins,
  2. traveler's checks, and
  3. checking accounts (demand deposits).

M2 gives a broader definition of money and comprises

  1. all components of M1,
  2. savings and time deposits of less than $100,000,
  3. money market mutual funds held by individuals, and
  4. Eurodollars (U.S. dollars that are deposited in European banks).

M1 and M2, to a lesser extent, share the characteristic of being highly liquid, where liquidity is the term that describes the ease of converting an asset into money. With cash being perfectly liquid, a checking account is nearly so.

When the Federal Reserve changes the money supply, it targets M2. Although there are even broader definitions of money known as M3 and L, we need only concern ourselves with M1 and M2.

Some Early U.S. Banking History

The basic functions of banks are to collect savings and loan to businesses and consumers. Banks were found in early civilizations, especially in Rome, where banks made loans and exchanged foreign currencies. The penalty for failing to repay a loan in Rome was severe -people who defaulted on loans became the slaves of their creditor. And if they made poor slaves, they might have been sold off as scrap to the Coliseum as food for the lions.

Modern banking originated in Renaissance Italy where bankers traded currencies and took in demand (checking) and time (savings) deposits. The most common check of this era was an oral transaction. Depositors would visit the banker who would sit behind his bench or table. The expression "bankruptcy" comes from the Italian custom of breaking the bench of a banker who could not return the deposits of his creditors.

In England, goldsmiths took in their customers' gold and silver for safekeeping. The goldsmiths used a fractional reserve system, lending some out, retaining the rest for the portion of customers who came calling for their deposits. As a record, depositors were given receipts that were transferable to other people (an early checking system), who could collect the corresponding amount of gold or silver.

In colonial America, the first bank was founded in 1782 and was known as the Bank of North America. At this time all banks were state chartered and the banking system grew rapidly, although many new banks were unsound and two out of five failed. The founding fathers of the United States were a suspicious lot when it came to banking matters. Thomas Jefferson considered a standing army and a strong banking system to be the two major threats to a democracy. As a result, the early U.S. banking system allowed for each state to control the banks chartered within its border. And state banks were allowed to print their own currency. By ensuring a multicurrency banking system, problems resulted in currency convertibility, especially for transactions that took place across states.

In 1791, Alexander Hamilton encouraged Congress to charter the First Bank of the United States, which was the first nationally chartered bank. Part of the goal of the First Bank was to control the excessive issuing of money by state banks. Offending banks would find that the First Bank would refuse to honor their script or be required to redeem their script issues in gold.

The early United States had no national currency, which would require some concentration of strength in the bank(s) that issued the nation's currency. After the First Bank's charter expired in 1811, the Second Bank of the United States was chartered in 1816. Never a supporter of concentrated banking and with a dislike for the Second Bank's president, President Andrew Jackson did not renew the bank's charter, allowing it to expire in 1836. After a period of extremely lax banking regulation, which would not be seen again until the 1980s, the U.S. Civil War necessitated further reform of banking. Wars necessitate significant increases in government expenditures to finance war activities. To raise money, governments can use some combination of taxes and obtaining loans from its citizens. A sound banking system encourages citizens to save with the banks, money which the government can easily borrow.

In order to raise money and encourage its citizens to save with banks, the northern Congress passed the National Currency Act of 1863. This law set up a system of nationally chartered banks that issued the first national currency, the greenback, which became the standard currency for the remainder of the century. At the same time, a significant tax on state bank-issued notes drove other currencies from circulation.

A major problem facing the rapidly expanding U.S. economy during the later part of the nineteenth and early part of the twentieth centuries was severe economic business cycles. The economy went through frequent boom-depression cycles. Many of the economic downturns were caused by a rapid escalation of the interest rate at which people and businesses borrowed. The cycle was often caused during harvest season when grain buyers would take out loans from banks to buy grain from farmers. The sudden acceleration in the demand for money and lending activity would quickly drive up the price of money (the interest rate) as the supply of loanable funds (savings) remained relatively constant. Surging interest rates would crowd out borrowing by the commercial and consumer sectors, leading to a reduction in spending, sometimes causing a recession or depression.

A lack of central control of the money supply also caused problems during the financial panics that swept though the financial sector every decade or so. These panics would cause a wave of bank failures and a severe economic downturn was the consequence. In response to the business cycles caused by scorching interest rates and financial panics, the government decided it needed to be able to increase the money available for banks to loan during periods of high demand, which would help to maintain stable interest rates, and increase bank liquidity during times of panic withdrawals. Despite strong opposition and fears that a central bank would lead to a banking cartel run by bankers, the Federal Reserve Act of 1913 created the Federal Reserve Board. The Federal Reserve was given the responsibility of controlling the money supply and stabilizing the financial system.

The Structure of the Federal Reserve Board (Fed)

The headquarters of the Federal Reserve System is located in Washington, D.C. and is known as the Board of Governors. Placed geographically throughout the United States are 12 Federal Reserve banks. Fed policy is made by the politically appointed Fed chairman (currently Alan Greenspan) and the Federal Open Market Committee (FOMC), comprising the political appointees on the Board of Governors plus 5 of the 12 regional Fed bank presidents. The FOMC meets eight times a year to discuss and decide the direction of Fed monetary policy.

Despite the political nature of important decision-making appointments at the Fed, once in place Fed members are expected to make decisions without significant political pressure. The Fed makes policy choices independent of the executive and legislative branches of government. Although the president and Congress will often voice their displeasure when the Fed is carrying out economic policies with which they disagree, the Fed is free to (and often does) disregard these potential influences. This is part of the checks and balances found in government. Although there is occasional discussion by lawmakers of "reeling in" the Fed and making it more accountable, Fed independence also provides a convenient outlet for political/economic ineptitude. When the economy goes into the tank, the Fed offers a convenient scapegoat for the president and Congress on which to focus the unhappy public's attention (1).

(1)The Fed chairman and six members of the Federal Reserve Board of Governors in Washington D.C. are appointed by the President and approved by the Senate. To insulate these FOMC members from short-term political pressures the chairman is appointed for four-year terms and other Board of Governors members are given 14-year memberships (with no limit on renewals). The other members of the FOMC are comprised of the presidents of the 12 regional Federal Reserve banks. Each is chosen by their respective boards of directors and approved by the Board of Governors. Although most of the regional banks presidents are present at FOMC meetings, only five have a vote on Fed policy at any given time.

In many ways, it the Fed staff and Chairman that dictate Fed policy by controlling how the economy is modeled and analyzed. The conclusions of the forecast of future economic condition are prepared by the Fed staff and presented to the FOMC in the Green Book. The potential consequences of Fed policy on financial and other are outlined to FOMC members in the Blue Book.

Arguments in defense of Fed procedures include the need for the Fed staff to create forecasts independent of the policy views and possible biases of the influential FOMC members. Furthermore, each of the twelve regional Fed bank presidents has a sizeable research staff of his or her own which prepare their own independent forecasts that may be introduced into FOMC meetings.

When the FOMC meets every other month, plus an additional meeting in December, it can make several decisions regarding monetary policy. It can decide to raise, lower or leave the fed funds interest rate unchanged.

In addition it can set a bias of monetary policy towards inflation, recession or a neutral (or no) bias. The bias is important because it allows the Chair of the Fed to act unilaterally in changing the fed funds rate between FOMC meetings.

For example, in late 2000, the FOMC changed its viewpoint to a bias against an economic slowdown or a recession. This was a result of the weakening economy and the concern that the US might be heading for a recession. By setting the bias against a recession, Fed Chair Alan Greenspan was able to reduce the fed funds rate several times on his own initiative in 2001.

In 2002, the FOMC changed the bias to neutral. When the bias is neutral, the Federal Reserve Chair can no longer act on his own to change the fed funds rate. With a neutral bias, Greenspan must wait for the FOMC to met and to vote to change the fed funds rate. It is only when there is a bias against recession or inflation that the Fed Chair can act on his own without the FOMC vote of approval.

In this Topic we study monetary policy, which is used by the Fed to influence economic growth and thus unemployment and inflation rates. When the Fed conducts monetary policy, it measures the current and projected future condition of the economy. It can follow one of three options:

  1. Restrictive, which involves:
    • decreasing the money supply to:
    • raise interest rates, and to
    • slow economic growth.
  2. Neutral, the Fed may be happy with the current and projected outlook or may require more evidence before deciding to act.
  3. Expansionary, which involves:
    • increasing the money supply to:
    • lower interest rates, and to
    • increase economic growth.

The Fed carries out its policies through what is known as open market operations, which involves the buying and selling of bonds.

The major source of money the Fed has at its disposal is from banks in the form of required reserves. The Fed requires all banks and similar financial institutions that operate in the United States to keep 10% (a dime) of every dollar deposited on reserve with the Fed. Although, this money is a liability from the Fed to a bank, the Fed can use this money to conduct open market operations. We will see how this works in the next section. Note that the figure given, 10%, is known as the reserve requirement.

The Money Multiplier

The creation of the FDIC

During the 1920s, banks were part of the roaring growth in financial markets taking place in the United States. Looking for ways to make greater profits, banks actively participated in the stock market. Banks would take in deposits and not only make loans to businesses and individuals, but would buy stocks of companies. Furthermore, banks would make loans that used stocks as collateral. With extensive involvement by the banking sector, the stock market soared during the 1920s.

Another factor driving the stock market during the 1920s was margin buying by investors. Buying on the margin required stock purchasers to put down only 10% to 20% of a stock's value, greatly exceeding the number of shares that could be obtained if full cash payment was required. Given the volatility of stock prices, this practice significantly increased the risk exposure of investors.

Given the frenzy of stock market activity caused by the reckless investing of individuals, businesses, and banks, the stage was set for the devastating crash of 1929. After a decade of tremendous growth, stock prices plummeted in the fall of 1929. The effects were immediate. Individual investors were required to meet their margin requirements and needed to raise cash immediately. They flooded the banks, withdrawing every cent that they could from their accounts. Since the majority of depositors' money had been lent out by the banks, much of it to purchase what was almost equally worthless stocks, the money available in bank vaults was rapidly depleted. Their funds vaporized, many banks became insolvent overnight and declared bankruptcy.

The overall situation in the fall and winter of 1929 was chaos and panic. News of bank failures caused depositors to withdraw their money from even well run banks. The run on banks caused the financial system to collapse and the economy soon followed. The United States economy went into the Great Depression, which would last until World War II.

One of the major causes of bank failure during the panics of 1929 and the early 1930s was caused by the rapid withdrawal of deposits by nervous savers. At the time, if a bank failed, depositors who had accounts with the bank risked losing a major portion or even all of their money. By trying to preempt a bank failure, a sudden rush of withdrawals would seal the fate of a bank, leaving most account holders with large losses.

To stop the panic, the Roosevelt administration created the Federal Deposit Insurance Agency (FDIC) in 1933, followed by the FSLIC (for Savings and Loans) in 1934. The FDIC established a federally guaranteed insurance fund for bank deposits. People were assured that even if a bank failed their deposits would be covered in full up to a mandated limit (although the limit is seldom enforced). The FDIC required banks to pay a small insurance premium based on the value of deposits into a fund. With this government program in place, the panic runs on banks ended and the banking system would remain very stable until the wildcat frenzy of banking deregulation in the 1980s.

How Banks Create Money

Please note that the discussion also applies to other depository institutions such as savings and loans, and credit unions, as well as banks.

When a customer makes a deposit into his account at a bank, this creates a liability for the bank. A liability describes the bank's obligations, or what it owes to others. In other words, the bank is liable for the amount of the deposit. On the other side of the coin, the deposit creates an asset for the bank. The bank now owns the value of the deposit and will put the money to work, looking for a rate of return that exceeds the interest it pays on the liability. This is the business of banking. By offering savers a return (and/or other services), banks take in deposits (liabilities), which creates assets that a bank can lend out. As long as the total return on assets exceeds the payment on liabilities (and other costs of doing business) the bank is profitable.

When a bank receives a deposit, it must keep a portion on reserve with the Federal Reserve (Fed) and pay a deposit insurance premium to the FDIC. At the present time, the Fed's reserve requirement is 10%. With this in mind, let us use a few balance sheets to demonstrate how banks create money from deposits. We will see that for every dollar deposited, the money supply increases by a multiple of the amount deposited.

Let us first examine the balance sheet of Glen Echo Bank. We see in Table 10-1 that the value of total liabilities to Glen Echo equals $100 million. In addition, the bank is required to have its own net worth as a buffer against bad loans and insolvency. Net worth is considered the value of the owners (share holders) stake in the bank. In this case, net worth is 3% of total liabilities and equals $3 million, which the bank raised by selling shares of stock to the public. The bank is obligated to hold reserves of 10% of total deposits with the Fed, in this case the amount of required reserves is $10.0 million ($100.0 million in deposits x 0.10).

Table 10-1: Glen Echo Bank Balance Sheet (1)

Initial Balance
Assets Liabilites

Loans Outstanding $ 80.0 million Deposits $100.0 million
Government debt 13.0 million Net Worth 3.0 million
Required Reserves 10.0 million
Total 103.0 million Total 103.0 million

Consider a hard-working, thrifty (and rich) person like yourself. Let us assume that you deposit $1 million in your account at Glen Echo Bank. On the balance sheet that follows, Glen Echo now has an additional $1 million liability. Let us assume that the deposit insurance premium has no affect on our analysis, since it is so small. Your deposit also creates an additional $1 million in assets. Of your $1 million deposit, $100,000 (10%) is legally required to be kept as reserves with the Fed.

Table 10-2: Glen Echo Bank Balance Sheet (2) (Add $1.0 million deposit from you)

After $1 million deposit
Assets Liabilites

Loans Outstanding $ 80.9 million Deposits $101.0 million
Government debt 13.0 million Net Worth 3.0 million
Required Reserves 10.1 million
Total 104.0 million Total 104.0 million

Notice in Table 10-2 what the bank did with your $1 million deposit. $100,000 went to the reserve requirement with the Fed, and the bank lent out the other $900,000 (loans outstanding increased from $80 million to $80.9 million). For simplicity, let us assume that the entire $900,000 made available by your deposit was borrowed by one business: Joe-Bob's Rooter.

Joe-Bob doesn't borrow the money for fun, he wants to invest in new capital equipment, which will increase the productivity of his workers. Joe-Bob wants to invest in a new laser rooter, for which he pays $900,000 to Sapphire Slick's Laser Emporium. Let us also assume that Sapphire has an account with Glen Echo Bank, where she deposits the $900,000 received from Joe-Bob's purchase. Table 10-3 shows the new balance sheet for Glen Echo Bank after Sapphire's deposit.

Table 10-3: Glen Echo Bank Balance Sheet (3)
(Add $0.9 million deposit from Sapphire Slick)

After $0.9 million deposit
Assets Liabilites

Loans Outstanding $81.71 million Deposits $101.9 million
Government debt 13.00 million Net Worth 3.0 million
Required Reserves 10.19 million
Total 104.90 million Total 104.9 million

Several things have occurred due to Sapphire's deposit of $900,000 in the Glen Echo Bank.

  1. Total deposits increased from $101 million to $101.9 million.
  2. Required reserves increased by $90,000 (= $900,000 x .10).
  3. Total required reserves increased from $10.1 million to $10.19 million.
  4. The bank was able to lend out the difference between the deposit ($900,000) and required reserves ($90,000), an amount equal to $810,000.
  5. Outstanding loans increased from $80.9 million to $81.71 million ($80.9 + 0.810)

As we have shown, after meeting the reserve requirement, Glen Echo Bank loans out all the additional money available. You should be getting the basic idea: your initial deposit has triggered multiple rounds of lending and deposit activity. Things are happening well beyond your initial deposit. We can complete another round like the previous round, where someone borrows the money, spends it, and the recipient deposits the money in Glen Echo. However, rather than continue the tedious math, we can invoke the simple money multiplier to summarize our situation.

For the purposes of this course, we can define the money multiplier as equal to

= 1/r.r.

which equals to one divided by the reserve requirement. While we will work with the simple multiplier, in reality there are a number of leakages from the above scenario that will reduce the value of the multiplier:

  1. People may not deposit all of their cash into the banking system. Besides the money we keep in our wallets, we may save some of our money outside the depository banking system.
  2. Banks may not loan out all potential reserves, choosing to keep excess reserves.

Note that in our example we assumed that all deposits end up in the same bank. As long as deposits end up in the domestic banking system the result is the same. The money multiplier will attain the same value as shown in this example, and the overall increase in the money supply will be the same.

The Monetary Base and Money Supply

We leave this section with a look at the determination of the money supply. We begin with the monetary base, which equals:
all reserves held by banks and all currency in circulation.

A given amount of the monetary base allows for the creation of a multiple amount of money. As we shall see in the next section, the Fed uses its policy tools to alter the amount of money in the base, and thus the money supply.

The next part of the determination of the money supply is the process of transforming the monetary base into the money supply. Through the multiple deposit expansion described above, where money is deposited, loaned, and redeposited into the banking system, the money supply is determined. By definition, the money supply equals:

Money supply = (Monetary base) x (Money multiplier)


Change in the Money supply = (Change in the Monetary base) x (Money multiplier)

From our example given above, a deposit of $1 million adds the same amount to banking reserves. The money multiplier equals 1/r.r. (reserve requirement), which in this case is 1/.10, yielding a money multiplier of 10. The resulting increase in the money supply is $10 million (a $1 million deposit times a multiplier of 10).

Copyright 2003, Jay Kaplan
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