Study Mode #1

Banks create money by making loans. They can make loans when they have excess reserve.

Excess reserves = Actual Reserves - Required Reserves

Required Reserve = Deposits x Required Reserve Ration

So when a bank makes a loan, it creates a new deposit to the person who receives the loan. The bank uses its excess reserves to create new deposits and it can make loans equal to the amount of its excess reserves.

The amount of loans a bank can make and the amount of deposit they can create is limited by 2 factors;

1. Amount of excess reserves
2. Required Reserve Ratio (R)