Depository Institutions, Essay Example

Fractional Reserve Banking and the Money Multiplier

One of the main economic tools of the United States government is monetary policy, which allows them to directly influence growth and inflation rates in the country. This policy is administered by the Federal Reserve, the nation’s central bank. The Fed has many potential tools for influencing the economy, one of which is their open market operations. The bank can either buy or sell treasury bonds, which can increase or decrease the nation’s money supply, respectively. Buying bonds from banks gives them more money, which helps grow the economy through the monetary multiplier effect. Due to the nature of the fractional reserve banking system, a bank can loan out more money than it has on hand, meaning an injection of cash can be loaned out several times over.

For example, if the Federal Reserve buys five hundred thousand dollars worth of treasury bills from a bank, that bank will have half a million more dollars in reserves. With a reserve ratio of fifteen percent, the bank can loan out an increased amount of money, as long as they maintain that ratio of reserves. The way to calculate the multiplier is to multiply the new reserve total times the multiplier effect, which is the reciprocal of the reserve ratio. In this case 500,000*(1/.15), which equals 3,333,333 in new money injected to the economy. It is given in the problem that they will hold no excess reserves, so the multiplier will be this amount. In real life situations, the banks may occasionally hold on to some of the new funds to recapitalize, meaning the multiplier can be lower in practice (Mankiw, 2009).

When a bank receives money, they seek to increase the value of loans they have out as loans are where they profit. The Federal Reserve buys bonds from a bank and the bank now has more checkable deposits. This gives them excess reserves, reserves beyond the legal requirement they must keep. For this reason, the bank can loan out more money. Someone receives the money from the bank in the form of a loan, which they will spend. Whoever receives the money from the initial loanee can now deposit it in their bank. This increases the excess reserves at that second bank, who can now loan out money themselves. This process is repeated as the money from the second bank’s loan ends up in the reserves of another bank, who loans out the money again (Federal Reserve, 1994).

In the given situation, Bank A receives 500,000 dollars. This money is now excess reserves, so they can loan out the entirety of it. Someone receives this half million dollars, spends it, and whoever receives this money can deposit it. Bank B receives this money in a deposit, and can loan out eighty five percent of it themselves. Bank B can therefore loan out 425,000 of it. This money comes to Bank C, who does as Banks A and B did, loaning out 361,250. In total, the first three banks have loaned out over double what the Federal Reserve initially injected into the economy. This process continues, with the loaned money ending up in these first banks again or new financial institutions, which continue to loan money out.

This process creates money because the loan increases the assets of the initial bank and a second party. Someone has more money from the initial loan, while the bank still has the value of the loan on its balance sheet as an asset as it is owed this money and should eventually receive it. An initial injection of five hundred thousand dollars will be five hundred thousand dollars worth of assets to the bank, a combination of excess reserves and the outstanding loan. Assuming the fifteen percent reserve requirement, someone will now have an asset of four hundred and twenty five thousand dollars. When the money is repaid, the money supply will shrink as the bank will be the only ones holding it, although they can loan it out again if it is not essential to meeting reserve requirements (Krugman, 2009). The Federal Reserve can start it by turning bank assets, usually treasury bonds, into the more liquid asset of cash reserves.

The monetary multiplier is one of the main reasons that monetary policy can be so effective at encouraging growth in the economy. A small injection of money into the economy can be loaned out many times over, with the result being that much more money is created than the Federal Reserve initially spent. Conversely, they can sell treasury bonds, collect the money from banks, lower their excess reserves and the total number of loans. This policy harms growth, but can be necessary to slow inflation in an economy by decreasing the money supply. For expansionary policy, any method of increasing bank reserves should work to start this process. However, in some cases banks feel the need to recapitalize or find potential loans too risky to undertake. For that reason, this policy is not always effective. If a bank holds on to its new excess reserves, then the only increase in the money supply comes the initial action of the Federal Reserve buying treasury bonds.

Works Cited

Federal Reserve. (1994, February). Modern money mechanics. Retrieved from ://upload.wikimedia.org/wikipedia/commons/4/4a/Modern_Money_Mechanics.pdf

Krugman, P., & Wells, R. (2009). Macroeconomics. (pp. 393-396). New York, NY: Worth Publishers. Retrieved from http://books.google.com/books?id=dpTBdNGGrtUC&pg=PA393

Mankiw, G. (2009). Principles of economics. (pp. 347-349). South-Western College Publishing. Retrieved from http://books.google.com/books?id=58KxPNa0hF4C&pg=PT347