Modern Money Mechanics

A Workbook on Bank Reserves and Deposit Expansion

Federal Reserve Bank of Chicago

Page 8

This is the beginning of the deposit expansion process

In the first stage of the process, total loans and deposits of the banks rise by an amount equal to the excess reserves existing before any loans were made (90 percent of the initial deposit increase). At the end of Stage 1, deposits have risen a total of $19,000 (the initial $10,000 provided by the Federal Reserve's action plus the $9,000 in deposits created by Stage 1 banks). See illustration 4. However, only $900 (10 percent of $9,000) of excess reserves have been absorbed by the additional deposit growth at Stage 1 banks. See illustration 5.

The lending banks, however, do not expect to retain the deposits they create through their loan operations. Borrowers write checks that probably will be deposited in other banks. As these checks move through the collection process, the Federal Reserve Banks debit the reserve accounts of the paying banks (Stage 1 banks) and credit those of the receiving banks. See illustration 6.

Whether Stage 1 banks actually do lose the deposits to other banks or whether any or all of the borrowers' checks are re deposited in these same banks makes no difference in the expansion process. If the lending banks expect to lose these deposits - and an equal amount of reserves - as the borrowers' checks are paid, they will not lend more than their excess reserves. Like the original $10,000 deposit, the loan-created deposits may be transferred to other banks, but they remain somewhere in the banking system. Whichever banks receive them also acquire equal amounts of reserves, of which all but 10 percent will be "excess."

Assuming that the banks holding the $9,000 of deposits created in Stage 1 in turn make loans equal to their excess reserves, then loans and deposits will rise by a further $8,100 in the second stage of expansion. This process can continue until deposits have risen to the point where all reserves provided by the initial purchase of government securities by the Federal Reserve System are just sufficient to satisfy reserve requirements against the newly created deposits. (See page 10 and 11.)

The individual bank, of course, is not concerned as to the stages of expansion in which it may be participating. Inflows and outflows of deposits occur continuously. Any deposit received is new money, regardless of its ultimate source. But if bank policy is to make loans and investments equal to whatever reserves are in excess of legal requirements, the expansion process will be carried on.

How much Can Deposits Expand in the Banking System?

The total amount of expansion that can take place is illustrated on page 11. Carried through the theoretical limits, the initial $10,000 of reserves distributed within the banking system give rise to an expansion of $90,000 in bank credit (loans and investments) and supports a total of $100,000 in new deposits under a 10 percent reserve requirement. The deposit expansion factor for a given amount of new reserves is thus the reciprocal of the required reserve percentage (1/.10 = 10). Loan expansion will be less by the amount of the initial injection. The multiple expansion is possible because the banks as a group are like one large bank in which checks drawn against borrowers' deposits result in credits to accounts of other depositors, with no net change in total reserves.

Expansion through Bank Investments

Deposit expansion can proceed from investments as well as loans. Suppose that the demand for loans at some Stage 1 banks is slack. These banks would then probably purchase securities. If the sellers of the securities were customers, the banks would make payment by crediting the customers' transaction accounts; deposit liabilities would rise just as if loans had been made. More likely, these banks would purchase the securities through dealers, paying for them with checks on themselves or on their reserve accounts. These checks would be deposited in the sellers' banks. In either case, the net effects on the banking system are identical with those resulting from loan operations.

Page 9

4. As a result of the process so far, total assets and total liabilities of all banks together have risen 19,000.

(return to article at reference to illustration 4)

5. Excess reserves have been reduced by the amount required against the deposits created by the loans made in Stage 1.

(return to article at reference to illustration 5)

Why do these banks stop increasing their loans and deposits when they still have excess reserves?

6. ...because the borrowers write checks on their accounts at the lending banks. As these checks are deposited in the payee's banks and cleared, the deposits created by Stage 1 loans and an equal amount of reserves may be transferred to other banks.

(return to article at reference to illustration 6)

Deposit expansion has just begun!

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