Introduction to Finance

fractional reserve system 
banking 
system where depository institutions 
must hold funds in reserve equal to 
a certain percentage of their deposit 
liabilities
primary deposit 
deposit that adds 
new reserves to a bank
derivative deposit 
deposit of 
funds that were borrowed from the 
reserves of primary deposits

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C H A PT E R 5 Policy Makers and the Money Supply
withdrawal of the money. The bank statement, ignoring all other items, would then show 
the following:
Assets
Liabilities
Reserves
$10,000
Deposits
$10,000
Against this new deposit of $10,000, the bank must keep required reserves of 20 percent, 
or $2,000. Therefore, it has $8,000 of excess reserves available. Excess reserves are reserves 
above the level of required reserves.
It may appear that the banker could proceed to make loans for $40,000, since all that is 
needed is a 20 percent reserve against the resulting checkable deposits. If this were attemp-
ted, however, the banker would soon be in a diffi
cult situation. Since bank loans are usually 
obtained just before a demand for funds, checks would very likely be written against the 
deposit accounts almost at once. Many of these checks would be deposited in other banks, and 
the bank would be faced with a demand for cash as checks were presented for collection. This 
demand could reach the full $40,000. Since the bank has only $8,000 to meet it, it could not 
follow such a course and remain in business.
The amount that the banker can safely lend is the $8,000 of excess reserves. If more is 
lent, the banker runs the risk of not being able to make payments on checks. After an $8,000 
loan, the books show the following:
Assets
Liabilities
Reserves
$10,000
Deposits
$18,000
Loans
$ 8,000
If a check were written for the full amount of the derivative deposit ($8,000) and sent to 
a bank in another city for deposit, the lending bank would lose all of its excess reserves. This 
may be seen from its books, which would appear as follows: