Topic 4.4 Banking and the Expansion of the Money Supply: explain fractional-reserve banking, use a T-account balance sheet, and calculate the money multiplier and maximum change in the money supply.

What this topic is asking

Topic 4.4 explains how banks create money through lending. The College Board wants you to understand fractional-reserve banking, read a T-account (bank balance sheet), and calculate the money multiplier and the maximum change in the money supply. These calculations are exam staples and directly feed monetary policy.

Fractional-reserve banking

• Required reserves $=$ required reserve ratio $\times$ deposits.
• Excess reserves $=$ total reserves $-$ required reserves.

When a bank lends out its excess reserves, it creates new checkable deposits, expanding the money supply.

The T-account balance sheet

A bank's T-account is a simplified balance sheet: assets (what the bank owns: reserves and loans) on the left, liabilities (what it owes: deposits) on the right. The two sides always balance.

The money multiplier

When the first bank lends its $800, the borrower spends it, and the recipient deposits it in another bank, which keeps 20% and lends 80%, and so on. The rounds form a geometric series:

The maximum assumes banks lend out all excess reserves and the public redeposits everything. In reality, banks may hold extra reserves and people may hold cash, so the actual expansion is smaller.

Try this

Q1. Write the formula for the money multiplier. [1 point]

• Cue. Money multiplier $= \frac{1}{\text{required reserve ratio}}$.

Q2. A $1,000 deposit with a 10% reserve ratio. What are the excess reserves and the maximum money created? [2 points]

• Cue. Excess reserves $= 900$; multiplier $= 10$; maximum $= 900 \times 10 = 9{,}000$.