Money creation and fractional reserve

banking

November 12, 2014

 Money supply,
M = CU + DEP.

Monetary base,
BASE = CU + RES.

Divide one equation by another

CU + 1
M
cu + 1
CU + DEP
DEP
=
=
= CU
RES
BASE
CU + RES
cu + res
+
DEP
DEP

cu + 1
M = BASE
> BASE
cu + res

 Example: cu = 0 CU = 0.
Central bank issues $1 currency.
People have $1 additional money. If cu = 0, they deposit the entire
amount in banks.

1st round: Bankss deposit goes up by a $1.

Suppose res = 0.1. Banks then keep 0.1 $1 = $0.1 as RES and
loan out the rest ($0.9).

 Somebody (household or firm) gets a loan of $0.9. Given cu = 0, that

person deposits the entire amount in banks.

2nd round: Bankss deposit goes up by a $0.9.

Given res = 0.1. Banks then keep 0.1 $0.9 = $0.09 as RES
and loan out the rest ($0.90.9 = $0.81).

 Somebody (household or firm) gets a loan of $0.81. Given cu = 0,

that person deposits the entire amount in banks.

3rd round: Bankss deposit goes up by $0.81.

Given res = 0.1. Banks then keep 0.1 $0.81 = $0.081 as RES
and loan out the rest ($0.810.9 = $0.729).

 The process continues...

Deposits increase by
1 + 0.9 + 0.92 + 0.93 + ... = 1

1
1
=
= 10
1 0.9
0.1

In general with cu = 0,
M = DEP = BASE

1
= 10.
res

 The amount of RES

0.1 + 0.9 0.1 + 0.81 0.1 + ...

2
3
= 0.1 1 + 0.9 + 0.9 + 0.9 + ...

0.1
=1
0.1

In general, with CU = 0,
BASE = CU + RES = RES = 1