In this lesson, you'll learn how a single deposit in a local bank increases the money supply and filters through the economy with the help of the fractional reserve banking system.
How Money is Made
Go with me to the town of Ceelo where Cindy just graduated from college, thanks to Study.com. The good news is Cindy just got accepted as the vice president of a local company.
Cindy's dad Matt is a manufacturing worker in Ceelo who loves to pull levers and wear hard hats. Matt has recently been promoted to a high-level management position and now works 50 hours per week, earning about $5,000 a month.
Matt's uncle Fred works as a temporary Santa Claus at commodities trading firms, bringing holiday cheer and eating salmon from their buffet whenever possible. However, since Christmas, he's decided to start a company that makes business cards for Wall Street executives. Fred needs extra money to get started with this new business.
Fred's brother Frohm used to be a high school gym teacher, who tried desperately to teach kickboxing to the school's guinea pigs with the help of his students. However, in a surprising turn of events, he was let go. Now Frohm runs a guinea pig farm, and he's looking to expand his operation from ten piggies all the way up to a hundred. Frohm needs money to expand his business.
Frohm's cousin Vinny runs a sausage factory that requires lots of late night deliveries from around town. While he never reveals how the sausage is made, he makes a lot of it. Vinny needs some extra money to buy some new equipment for his factory, so he can dramatically increase production and get his sausages into the grocery stores across the town.
Matt takes his $5,000 paycheck to the First National Bank of Ceelo, where he can deposit it into an account. While he's at the bank, he sees his uncle Fred, who banks with another bank down the road. Fred is talking to a loan officer and waves hello from across the lobby. While Matt is waiting in line, he begins to wonder, how is money made?
Let's take a closer look at bank lending and see how money is made.
The Fractional Reserve Banking System
The bank serves an important purpose by connecting savers like Matt who want to earn a return on their money with borrowers like Fred who are willing to pay a price for the use of that money. The bank pays a relatively low interest rate to customers like Matt who deposit money into savings accounts and loan out most of this money to borrowers at a higher interest rate to people like Fred, keeping the difference. That's how the bank makes money. In this way, banking serves as the foundation of the economy because entrepreneurs and businesses borrow money to invest, and their investment produces economic growth.
Banks make money by charging higher interest rates to borrowers than the rates paid to savers.
The fractional reserve banking system is a system in which banks hold back a small fraction of their deposits in a reserve and loan out the rest of their deposits to borrowers. It was designed to ensure that while they are loaning out money, they have enough reserves on hand to cover any withdrawals that consumers want to make from their accounts.
When someone deposits money into an account at the bank, the bank does two things with it. Firstly, they set aside a fraction of it as a required reserve. Secondly, they loan out all the rest of it to borrowers. Suppose that Matt's account balance was $0 before he walked into the bank. Now assume that the Federal Reserve has set a required ratio for banks of 20%. It could be 10% or 15%, but let's say it's 20% right now. When Matt deposits $5,000, his account balance now says $5,000. Although he has the right to withdraw this money, the bank sets aside $1,000 of this $5,000 as required reserves. The rest of this deposit, which is $4,000, is considered by the bank as excess reserves, and the bank can now loan this out. As it turns out, Fred is in the bank right now talking to a loan officer, and he needs a loan in the amount of $4,000.
So, here's what this scenario looks like so far:
When Fred's loan application is approved, he walks out of the bank with a check in the amount of $4,000. He's quite excited because he'll get to buy the equipment he needs to create extraordinary business cards for the top 1% of the population. Truth be told, this $4,000 loan came from Matt's $5,000 deposit. Now Fred owes the bank $4,000, and the bank owes Matt $5,000. It kept $1,000 just in case Matt wants to withdraw some of the money now. The bank is happy because they'll get their money back plus interest, and the supply of money in the economy just went up by $4,000.
After putting aside a required reserve, the banks loan out the rest of a deposit.
Now suppose that Fred drives down the road to his bank, the Second Bank of Ceelo, where he stands in line to deposit his loan into an account. While he's standing in line, he sees his brother Frohm sitting in an office with a loan officer. For a brief moment, they see each other and wave hello. Fred deposits $4,000 in an account, and an hour later, Frohm walks out of the bank with a check for $3,200 on his way to guinea pig heaven. The bank keeps $800 out of the $4,000 deposit, according to their required reserve ratio of 20%. Once again, the money supply goes up, this time by another $3,200. That means in total, the money supply has increased by $4,000 plus $3,200 for a total of $7,200. Pretty cool, huh?
Now the process starts all over again, only this time Frohm takes his $3,200 check and goes to another bank and sees his cousin Vinny taking out a loan for $2,560, while the bank quietly reserves $640 out of that deposit behind the scenes. The money supply just went up another $2,560. In total, the money supply has increased - in other words, new money has been made or created - in the amount of $4,000 plus $3,200 plus $2,560 for a grand total of $9,760.
The important thing to note is that this whole process started from one single deposit of $5,000, and it will keep going, like a ripple effect through the economy. Money is made when banks loan out excess reserves. In addition, the money that banks loan out is used to invest into projects that increase economic growth. And who wouldn't be pleased to hear that as a result of the transactions we talked about, ten Wall Street bankers will get new business cards, the town of Ceelo will be graced with the presence of ninety new guinea pigs and everyone in the town of Ceelo will have the ability to enjoy Vinny's Italian sausages. While it is true that nobody, including Vinny, will tell you how the sausage really gets made, now you know how money is made.
Let's review. Banks serve an important purpose by connecting savers who want to earn a return on their money with borrowers who are willing to pay a price for the use of that money.
The fractional reserve banking system is a system in which banks hold a small fraction of their deposits in a reserve and loan out the rest of their deposits to borrowers. It was designed to ensure that while they are loaning out money, they have enough reserves on hand to cover any withdrawals that consumers want to make from their accounts.
When someone deposits money into an account at the bank, the bank does two things with it. Firstly, they set aside a fraction of it as a required reserve. Secondly, they loan out all the rest of it to borrowers.
Every time banks loan out the excess reserves, new money is created. A single deposit into the banking system can lead to a series of loans and deposits and turn a small amount of money into a large one.
As soon as you're done with this lesson, you should be ready to explain how the fractional reserve banking system works and discuss how money is made from a single bank deposit.