Introduction to Finance

Bank A
Assets
Liabilities
Reserves
$10,000
Deposits
$10,000
Securities costing $8,000 are purchased and the proceeds credited to the account of the 
seller, giving the following situation:
Bank A
Assets
Liabilities
Reserves
$10,000
Deposits
$18,000
Loans
$ 8,000
Assume that a check is drawn against the seller’s deposit and is deposited in Bank B. The 
books of the two banks would then show as follows:
Bank A
Assets
Liabilities
Reserves
$2,000
Deposits
$18,000
Loans
$8,000
Bank B
Assets
Liabilities
Reserves
$8,000
Deposits
$8,000
As in the case of a loan shown earlier, the derivative deposit has been transferred to Bank B, 
where it is received as a primary deposit.
At each stage in the process, 20 percent of the new primary deposit becomes required 
reserves, and 80 percent becomes excess reserves that can be lent out. In time, the whole of the 
original $10,000 primary deposit will have become required reserves, and $50,000 of deposits 
will have been credited to deposit accounts, of which $40,000 will have been lent out.
Table 5.1
further illustrates the deposit expansion process for a 20 percent reserve ratio. 
A primary deposit of $1,000 is injected into the banking system, making excess reserves of 
$800 available for loans and investments. Eventually, $5,000 in checkable deposits will be 
created.
Multiple expansions in the money supply created by the banking system through its 
expansion of checkable deposits also can be expressed in formula form as follows:
Change in checkable deposits =
Increase in excess reserves
Required reserves ratio
(5.1)
We defi ne the terms 
excess reserves 
and the 
required reserves ratio 
in the next section. 
For our purposes, the maximum increase in the amount of checkable deposits is determined 
by dividing a new infl ow of reserves into the banking system by the percentage of checkable 
deposits that must be held in reserves. 

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5.6 Changing the Money Supply
119
In the example presented in Table 5.1, the maximum expansion in the checkable deposits 
component of the money supply, which is the same as the fi nal-stage fi gure shown for checkable 
deposit liabilities, would be, as follows:
Change in checkable deposits = $1,000 ÷ .20 = $5,000
The maximum increase in deposits (and money supply) that can result from a specifi c increase 
in excess reserves is referred to as a 
money multiplier
. In our very basic example, the money 
multiplier (
m
) is equal to one divided by the required reserves ratio, or 
m
= 1 ÷ .20 = 5. 
However, in the complex U.S. economy there are several factors or “leakages” that reduce 
the ability to reach the maximum expansion in the money supply depicted in this simplifi ed 
example. We will discuss a more realistic money multiplier ratio in the last section of this 
chapter.
Off setting or Limiting Factors
Deposit creation can go on only to the extent that the activities described actually take place. If 
for any reason the proceeds of a loan are withdrawn from the banking system, no new deposit 
arises to continue the process. A new deposit of $10,000 permits loans of $8,000 under a 
20 percent required reserve, but if this $8,000 were used in currency transactions without 
being deposited in a bank, no deposit could be created. The custom of doing business by 
means of checks makes deposit creation possible.