Fractional Reserve Banking (How Money is Created)

When merchants began to travel more consistently across Europe in the 14th century they initially took on substantial risk by carrying valuable merchandise or precious metals in order to pay for their goods.

You can imagine what an opportunity this represented for thiefs...

In order to de-risk this process, banks began to issue promissory notes. A promissory note is simply an IOU to anyone depositing their valuables with the bank. It's a guarantee that the bank has those assets on hand and will be able to pay the holder of the note their value.

So now instead of moving your precious metals around, merchants could carry around promissory notes to exchange with other merchants. These notes effectively became their own medium of exchange (one of the three functions of money).

While this certainly reduced risk for merchants, the longer lasting and more profound change happened on the banking side. Not only did deposits grow in scale, but bankers began to realize that all their deposits would never be withdrawn at the same time.

Seeking to capitalize on this fact bankers began to lend out a percentage of those deposits to others in order to earn interest.

Multiplying Money

This was the foundation of our modern fractional reserve system. Today a bank only holds a fraction of its deposits in reserve and is able to lend the rest out (note there is usually a legal minimum percentage of deposits that must be held in reserve, which we refer to as the reserve requirement).

This fractional system creates a money multiplier effect anytime new money is deposited. That’s because when I deposit money a bank immediately loans out a percentage of that money.

But that’s not all.

The money that the bank loans out will itself be spent somewhere. In fact, it is likely that it ends up in another bank, which in turn lends out the portion it doesn’t have to hold in reserve. Thus any single deposit will end up creating some multiple of the original cash amount. We calculate this money multiplier as:

money multiplier= 1 / (reserve requirement (%))

Simply multiply the money multiplier by the original deposit to get the dollar amount of new money created. Or you can calculate it as:

New money created= (new deposit) / (reserve requirement)

As you can see, the higher the reserve requirement the lower the multiplier.

How this gets tested on Level 1

For the CFA Level 1 exam expect to need to calculate the amount of new money created based on a central bank's activity. Alternatively, you should be able to apply this concept to articulate why a central bank's activity may be more or less effective depending on the reserve requirement or a given money multiplier.