http://en.wikipedia.org/wiki/Fractional_reserve_banking

Money creation

Main article: money creation

Modern central banking allows multiple banks to practice fractional reserve banking with inter-bank business transactions without risking bankruptcy. The process of fractional-reserve banking has a cumulative effect of money creation by banks, essentially expanding the money supply of the economy.[6]
There are two types of money in a fractional-reserve banking system operating with a central bank:[12][13][14]
  1. central bank money (money created or adopted by the central bank regardless of its form (precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money)
  2. commercial bank money (demand deposits in the commercial banking system) - sometimes referred to as chequebook money[15]

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks reserves (it is no longer counted as part of m1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits. When a loan is made by the commercial bank (which keeps only a fraction of the central bank money as reserves), using the central bank money from the commercial bank's reserves, the m1 money supply expands by the size of the loan. [5] This process is called deposit multiplication.

Example of deposit multiplication


The table below displays how loans are funded and how the money supply is affected. It also shows how central bank money is used to create commercial bank money from an initial deposit of $100 of central bank money. In the example, the initial deposit is lent out 10 times with a fractional-reserve rate of 20% to ultimately create $400 of commercial bank money. Each successive bank involved in this process creates new commercial bank money on a diminishing portion of the original deposit of central bank money. This is because banks only lend out a portion of the central bank money deposited, in order to fulfill reserve requirements and to ensure that they always have enough reserves on hand to meet normal transaction demands.

The process begins when an initial $100 deposit of central bank money is made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as reserves, and then loans out the remaining 80 percent, or $80. At this point money supply actually totals $180, not $100; because the bank has loaned out $80 of the central bank money, kept $20 of central bank money in reserve (not part of the money supply), and substituted a newly created $100 IOU claim for the depositor that acts equivalently to and can be implicitly redeemed for central bank money (the depositor can transfer it to another account, write a check on it, demand his cash back, etc.).

These claims by depositors on banks are termed demand deposits or commercial bank money and are simply recorded in a bank's accounts as a liability (specifically, an IOU to the depositor). From a depositor's perspective, commercial money is equivalent to central bank money – it is impossible to tell the two forms of money apart unless a bank run occurs (at which time everyone wants central bank money).[5]

At this point, Bank A now only has $20 of central bank money on its books. The loan recipient is holding $80 in central bank money, but he soon spends the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in the same situation as Bank A started with, except it has a deposit of $80 of central bank money instead of $100. Similar to Bank A, Bank B sets aside 20 percent of that $80, or $16, as reserves and lends out the remaining $64, increasing money supply by $64. As the process continues, more commercial bank money is created. To simplify the table, a different bank is used for each deposit. In the real world, the money a bank lends may end up in the same bank so that it then has more money to lend out.

Table Sources: [16][17][18][12]||~ Individual Bank ||~ Amount Deposited ||~ Lent Out ||~ Reserves ||
A
100
80
20
B
80
64
16
C
64
51.20
12.80
D
51.20
40.96
10.24
E
40.96
32.77
8.19
F
32.77
26.21
6.55
G
26.21
20.97
5.24
H
20.97
16.78
4.19
I
16.78
13.42
3.36
J
13.42
10.74
2.68
K
10.74





Total Reserves:



89.26

Total Amount of Deposits:
Total Amount Lent Out:
Total Reserves + Last Amount Deposited:

457.05
357.05
100


external image Fractional_reserve_banking_20percent_100base.gifexternal image magnify-clip.png


The expansion of $100 of central bank money through fractional-reserve lending with a 20% reserve rate. $400 of commercial bank money is created virtually through loans.

Although no new money was physically created in addition to the initial $100 deposit, new commercial bank money is created through loans. The 2 boxes marked in red show the location of the original $100 deposit throughout the entire process. The total reserves plus the last deposit (or last loan, whichever is last) will always equal the original amount, which in this case is $100. As this process continues, more commercial bank money is created. The amounts in each step decrease towards a limit. If a graph is made showing the accumulation of deposits, one can see that the graph is curved and approaches a limit. This limit is the maximum amount of money that can be created with a given reserve rate. When the reserve rate is 20%, as in the example above, the maximum amount of total deposits that can be created is $500 and the maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a liability whereas the loan it gives out and the reserves are considered assets. Deposits will always equal to loans plus a bank's reserves, since loans and reserves are created from deposits. This is the basis for a bank's balance sheet.
The expansion and contraction of the money supply occurs through this money creation process. When loans are given out, the process moves from the top down and the money supply expands. When currency is withdrawn from the commercial banks, causing loans to be called back, the process moves from the bottom to the top and the money supply contracts.

This table gives an outline of the makeup of money supplies worldwide. Most of the money in any given money supply consists of commercial bank money.[12] The value of commercial bank money is based on the fact that it can be exchanged freely at a bank for central bank money.[12][13]
The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process.[19] Government regulations may also be used to limit the money creation process by preventing banks from giving out loans even though the reserve requirements have been fulfilled.[20]

Money multiplier

Main article: Money multiplierexternal image Fractional-reserve_banking_with_varying_reserve_requirements.gifexternal image magnify-clip.png

The expansion of $100 through fractional-reserve banking with varying reserve requirements. Each curve approaches a limit. This limit is the value that the money multiplier calculates.
The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:[21]
m=frac1R
m=frac1R

Example
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a fraction:
R=tfrac15
R=tfrac15

So then the money multiplier, m, will be calculated as:
m=1/tfrac15=5
m=1/tfrac15=5

This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to.
The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold—usually a small amount). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.[22] In practice, the actual money multiplier varies over time, and may be substantially lower than the theoretical maximum.[23]