4.4 Banking and the Expansion of the Money Supply

Banks use fractional reserve banking, meaning they hold only a fraction of deposits as reserves and lend out the rest, which creates new money in the economy. The money multiplier (1 divided by the required reserve ratio) tells you the maximum the money supply can grow from new excess reserves.

AP Macro 4.4 Banking and Money Supply Expansion

AP Macro 4.4 is about how banks expand the money supply through fractional reserve banking. A bank keeps required reserves, lends excess reserves, and those loans can be redeposited and lent again across the banking system.

The calculation sequence is the part to know cold: required reserves = required reserve ratio × deposit, excess reserves = deposit - required reserves, and maximum money multiplier = 1 / required reserve ratio. For a new cash deposit, the maximum change in the money supply is based on excess reserves, not the full deposit.

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Why This Matters for the AP Macroeconomics Exam

This topic is the bridge between how money is defined and how monetary policy actually works. Once you understand how excess reserves expand the money supply, you can explain why central bank actions change the amount of money in the economy. The financial sector is a heavily weighted part of the course, and banking calculations show up in both multiple-choice questions and free-response questions, often through balance sheets (T-accounts). Getting comfortable with the deposit-to-loan-to-redeposit chain also sets you up for later topics like the money market and monetary policy.

Key Takeaways

• Fractional reserve banking means banks keep only a portion of deposits as reserves and lend out the rest, which creates new money.
• Reserves split into two parts: required reserves (set by the required reserve ratio) and excess reserves (the part that can be loaned).
• Excess reserves are what drive the expansion of the money supply, not the whole deposit.
• The maximum money multiplier equals 1 divided by the required reserve ratio. A lower ratio gives a larger multiplier and more expansion.
• For a new cash deposit: maximum change in the money supply = initial excess reserves times the multiplier.
• The simple multiplier gives a maximum, so the real change is usually smaller because banks may hold extra reserves and people may keep some cash instead of redepositing.

Fractional Reserve Banking

Fractional reserve banking is the practice where a bank accepts deposits but holds only a fraction of those deposits as reserves. The required portion is set by the required reserve ratio (also called the reserve requirement). The bank can lend out the rest. By making those loans, the bank effectively creates new money in the economy.

Banks organize their assets and liabilities on balance sheets, and they operate using this fractional reserve system. The key idea: deposits do not just sit in a vault. The loanable portion gets spent, redeposited, and lent again, expanding the money supply over time.

Reserves: Required vs. Excess

A bank's reserves are split into two categories:

• Required reserves: the portion the bank must hold, equal to the required reserve ratio times deposits.
• Excess reserves: everything left over after required reserves, which the bank can loan out.

Excess reserves are the basis for the expansion of the money supply. If a bank has no excess reserves, it cannot make new loans.

The Money Multiplier

When a deposit is made, the excess reserves become new loans. Those loans get spent and redeposited, creating another round of excess reserves and more loans. This chain reaction is how the banking system multiplies money.

Two definitions to keep straight:

• The monetary base is the sum of currency in circulation and bank reserves.
• The money multiplier is the ratio of the money supply to the monetary base.

In the simple banking model, the maximum money multiplier is:

Maximum money multiplier = 1 ÷ required reserve ratio

This maximum assumes banks lend out all excess reserves and the public redeposits everything rather than holding extra cash.

How the Ratio Changes the Multiplier

• A lower required reserve ratio gives a larger multiplier and more money creation.
• A higher required reserve ratio gives a smaller multiplier and less money creation.

For example, a reserve ratio of 0.2 gives a multiplier of 1 ÷ 0.2 = 5. A reserve ratio of 0.5 gives a multiplier of 1 ÷ 0.5 = 2.

Worked Calculation

Suppose a bank receives a new cash deposit of $10,000 and the required reserve ratio is 20%.

1. Required reserves = 0.20 × $10,000 =$2,000
2. Excess reserves = $10,000 − $2,000 = $8,000
3. Money multiplier = 1 ÷ 0.20 = 5
4. Maximum change in the money supply = $8,000 × 5 =$40,000

Notice that the maximum change in demand deposits would be $10,000 × 5 =$50,000, but the maximum change in the money supply is $40,000. That gap exists because only the $8,000 of excess reserves can be loaned out to create additional checkable deposits.

Why the Real Change Is Usually Smaller

The simple money multiplier gives the maximum possible expansion. The actual increase is often smaller because:

• Banks may choose to hold some excess reserves instead of lending them all out.
• Households may keep some loan proceeds as currency instead of redepositing them (a currency drain).

Both of these reduce how much money the banking system can create.

Bank Balance Sheets (T-Accounts)

A bank balance sheet, also called a T-account, is a record of a bank's assets and liabilities. It is set up so that total assets always equal total liabilities.

• Assets are what the bank owns or what is owed to it: reserves, loans, and securities.
• Liabilities are what the bank owes to depositors: checkable deposits (including demand deposits).

A new cash deposit raises both reserves (an asset) and checkable deposits (a liability) by the same amount. When the bank makes a loan, excess reserves on the asset side convert into loans on the asset side.

Example: Second National Bank

Assume the reserve ratio is 10% (0.1), so the money multiplier is 10. Assume the bank lends out all excess reserves.

If the bank receives a demand deposit of $1,000:

1. Required reserves = 0.10 × $1,000 =$100
2. Excess reserves = $1,000 − $100 = $900
3. Maximum change in the money supply = $900 × 10 =$9,000

The $900 in excess reserves is what gets lent out and circulated to create the maximum change in the money supply.

How to Use This on the AP Macroeconomics Exam

Problem Solving

Use this order every time you see a deposit problem:

1. Find required reserves = required reserve ratio × deposit.
2. Find excess reserves = deposit − required reserves.
3. Find the money multiplier = 1 ÷ required reserve ratio.
4. Multiply the right starting number by the multiplier:
   • Maximum change in money supply and loans = initial excess reserves × multiplier.
   • Maximum change in demand deposits = initial deposit × multiplier.

Free Response

Balance sheet questions show up regularly on free response. Watch for these:

• If a bank already has zero excess reserves, the dollar value of new loans it can make is zero.
• Read carefully whether the question asks about the single bank or the whole banking system. A single bank can only loan its own excess reserves; the whole system multiplies them.
• When asked to explain, state that only excess reserves can be lent, which is why the money supply grows by excess reserves times the multiplier.
• If asked why the actual change is smaller than the maximum, name banks holding excess reserves or people holding extra currency.

Practice Free Response Question

Assume the required reserve ratio is 10 percent. The First Superior Bank has loaned out all of its excess reserves.

• (a) What is the dollar value of new loans First Superior Bank can make? Explain.
• (b) Mr. Smith deposits $100 of cash in a demand deposit account at First Superior Bank. Calculate the maximum amount of new loans First Superior Bank can now make.
• (c) As a result of the $100 cash deposit, calculate the maximum change over time in each of the following in the banking system:
  • (i) Loans
  • (ii) Demand deposits
• (d) As a result of the $100 cash deposit, calculate the maximum change over time in the money supply.
• (e) Provide one reason the actual change in the money supply can be smaller than the maximum in part (d).

Answers

• (a) Zero, because the bank has no excess reserves left to lend.
• (b) $90. Required reserves are $10 (10% of $100), so $90 goes into excess reserves and can be loaned out.
• (c)
  • (i) Maximum change in loans = $90 × 10 =$900.
  • (ii) Maximum change in demand deposits = $100 × 10 =$1,000.
• (d) Maximum change in the money supply = $90 × 10 =$900.
• (e) Banks may hold some excess reserves instead of lending them, and/or households may hold some loan proceeds as currency instead of redepositing them.

Common Misconceptions

• The whole deposit gets multiplied into new money. Only excess reserves expand the money supply. The required portion stays in reserve. The change in the money supply equals excess reserves times the multiplier, not the full deposit times the multiplier.
• The first bank can lend the full deposit. A single bank can only loan out its own excess reserves. The multiplied amount happens across the entire banking system, not at one bank.
• A higher reserve ratio means more money creation. It is the opposite. A higher ratio shrinks the multiplier and limits expansion. A lower ratio grows the multiplier.
• The maximum and the actual change are the same. The simple multiplier gives a ceiling. Real expansion is smaller when banks hold extra reserves or people keep cash.
• Reserves and loans are both liabilities. Reserves, loans, and securities are assets. Checkable deposits are liabilities. Mixing these up will sink a balance sheet question.
• Demand deposits and money supply always change by the same amount. They can differ. Demand deposits change by deposit times the multiplier, while the money supply changes by excess reserves times the multiplier when the starting deposit is cash.

Related AP Macroeconomics Guides

• 4.1 Financial Assets
• 4.3 Definition, Measurement, and Functions of Money
• 4.2 Nominal vs. Real Interest Rates
• 4.5 The Money Market
• 4.6 Monetary Policy
• 4.7 The Loanable Funds Market