4.4 Banking and the Expansion of the Money Supply

a. Define key terms related to the banking system and the expansion of the money supply. b. Explain how the banking system creates and expands the money supply. c. Calculate (using data and balance sheets as appropriate) the effects of changes in the banking system.

• Depository institutions (such as commercial banks) organize their assets and liabilities on balance sheets.
• Depository institutions operate using fractional reserve banking.
• Banks’ reserves are divided into required reserves and excess reserves.
• Excess reserves are the basis of expansion of the money supply by the banking system.
• The money multiplier is the ratio of the money supply to the monetary base.
• The size of expansion of the money supply depends on the money multiplier.
• The maximum value of the money multiplier can be calculated as the reciprocal of the required reserve ratio.
• The amount predicted by the simple money multiplier may be overstated because it does not take into account a bank’s desire to hold excess reserves or the public holding more currency.
• Enduring understanding POL-2: The banking system plays an important role in the expansion of the money supply.