Introduction to Finance

Assets
Liabilities
Reserves
$2,000
Deposits
$10,000
Loans
$8,000
In practice, a bank may be able to lend somewhat more than the $8,000 in this example, 
because banks frequently require customers to keep an average deposit balance of about 
15 to 20 percent of the loan. The whole of the additional $1,500 to $2,000 cannot be lent 
safely, because an average balance of $1,500 to $2,000 does not prevent the full amount of the 
loan from being used for a period of time. With an average balance in each derivative deposit 
account, however, not all accounts will be drawn to zero at the same time. Therefore, some 
additional funds will be available for loans.
It may be argued that a banker will feel sure that some checks written against the bank 
will be redeposited in the same bank and, therefore, larger sums can be lent. However, 
because any bank is only one of thousands, the banker cannot usually count on such rede-
positing of funds. Banks cannot run the risk of being caught short of reserves. Thus, when 
an individual bank receives a new primary deposit, it cannot lend the full amount of that 
deposit but only the amount available as excess reserves. From the point of view of an indi-
vidual bank, therefore, deposit creation appears impossible. Because a part of every new 
deposit cannot be lent out due to reserve requirements, the volume of additional loans is less 
than new primary deposits.
It is important to recognize that 
what cannot be done by an individual bank can be 
done by the banking system. 
This occurs when many banks are expanding loans and deriv-
ative deposits at the same time. To illustrate this point, assume that we have an economy 
with just two banks, A and B. This example can be realistic if we assume, further, that 

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5.6 Changing the Money Supply
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Bank A represents one bank in the system and Bank B represents all other banks com-
bined. Bank A, as in our previous example, receives a new primary deposit of $10,000 
and is required to keep reserves of 20 percent against deposits. Therefore, its books would 
appear as follows: