# Money Creation

> AP Macroeconomics · Unit 4: Financial Sector
> Source: https://www.owlsprep.com/study/ap-macroeconomics-u4-money-creation/

This sub-topic covers fractional reserve banking, required and excess reserves, simple and adjusted money multipliers, bank balance sheet accounting, and leakages in money creation, a core 10-15% weighted topic for AP Macroeconomics Unit 4.

**Prerequisites:** [Definition and measurement of money (M1, M2)](https://www.owlsprep.com/study/ap-macroeconomics-u4-money-measurement/); Structure of commercial banks and central banks; Bank reserves and monetary base

## Learning objectives

- Explain how fractional reserve banking enables money creation
- Calculate required reserves, excess reserves, and money multipliers
- Analyze money creation using commercial bank balance sheets
- Identify how leakages reduce the size of the money multiplier

## What Is Money Creation?

Money creation (also called multiple deposit creation or money supply expansion) is the process by which the commercial banking system expands the overall money supply beyond the initial amount of base money injected by the central bank. This process relies entirely on fractional reserve banking, the standard system operating in all modern economies.

A common misconception is that money creation is only the central bank "printing money": in reality, most of the broad money supply (M1/M2) in modern economies is created by commercial banks through lending, not by the central bank directly.

## Fractional Reserve Banking and Reserve Requirements

Fractional reserve banking is the core institutional arrangement that enables money creation. Under this system, central banks require commercial banks to hold a fixed fraction of their deposits as reserves (vault cash plus deposits held at the central bank).

**Required Reserve Ratio** — The fixed fraction of total checkable deposits that commercial banks are required to hold as reserves and cannot lend out.

*Notation:* $rr$

*Example:* A 15% required reserve ratio means banks must hold \$15 of reserves for every \$100 of deposits.

The portion of deposits that banks hold above the required amount is called excess reserves ($ER$), which banks can lend out to borrowers. When a bank makes a loan, it credits the borrower’s checking account, increasing total checkable deposits (and thus M1) immediately. The loan is spent, the recipient deposits the funds into another bank, which keeps the required amount in reserves and lends out the rest. This repeated cycle expands the total money supply multiple times over the initial reserve injection.

Required reserves are calculated as:

$$RR = rr \times D$$

where $D$ is total checkable deposits. Excess reserves are calculated as:

$$ER = \text{Total Reserves} - RR$$

**Worked example:** A commercial bank receives a new \$4,000 deposit from a customer. The required reserve ratio is 15%. Calculate required reserves and excess reserves for this deposit, and identify how much the bank can lend out.

1. Identify given values:

   $$D = \$4{,}000, \ rr = 0.15$$
2. Calculate required reserves:

   $$RR = 0.15 \times 4000 = \$600$$
3. Calculate excess reserves:

   $$ER = 4000 - 600 = \$3{,}400$$
4. The bank can lend out all excess reserves if it chooses to, so the maximum possible loan amount is \$3,400.

> **Exam tip:** Always confirm whether the deposit is new to the entire banking system or just a transfer between banks—only new deposits increase total reserves and enable new money creation.

## The Money Multiplier (Simple and Adjusted)

The money multiplier measures how much the total money supply increases for every \$1 of new reserves injected into the banking system. The simple money multiplier assumes two key conditions: (1) banks lend out all excess reserves (so $e = 0$, no excess reserves held) and (2) the public holds no currency (so $c = 0$, all loan proceeds are re-deposited into banks). Under these assumptions, the simple money multiplier is:

$$mm_s = \frac{1}{rr}$$

In the real world, leakages exist: banks often hold excess reserves for liquidity, and the public holds some currency for transactions instead of depositing all funds. Both leakages reduce the amount of money that can be re-lent at each step of the cycle, so the actual (adjusted) money multiplier is smaller than the simple multiplier. The adjusted formula for the money multiplier is:

$$mm_a = \frac{1 + c}{rr + c + e}$$

The total change in the money supply is always $\Delta M_s = \Delta R \times mm$, where $\Delta R$ is the change in total reserves.

**Worked example:** The required reserve ratio is 10%, banks hold 8% of deposits as excess reserves, and the public holds a currency-deposit ratio of 12%. The central bank injects \$200 billion in new reserves. Calculate the actual total change in the money supply, and compare it to the change implied by the simple multiplier.

1. List given values:

   $$rr = 0.10, \ e = 0.08, \ c = 0.12, \ \Delta R = \$200 \text{ billion}$$
2. Calculate adjusted multiplier:

   $$mm_a = \frac{1 + 0.12}{0.10 + 0.12 + 0.08} = \frac{1.12}{0.30} \approx 3.73$$
3. Actual change in money supply:

   $$\Delta M_s = 200 \times 3.73 \approx \$746 \text{ billion}$$
4. Simple multiplier calculation:

   $$mm_s = 1/0.10 = 10, \ \text{so } \Delta M_s = 200 \times 10 = \$2{,}000 \text{ billion}. \text{ Leakages reduce total money creation by more than 60% compared to the simple model}.$$

> **Exam tip:** On FRQs, you must explicitly state your assumptions (e.g., "no excess reserves, no currency leakage") when using the simple multiplier to earn full points.

## Bank Balance Sheets and Money Creation

Money creation can be clearly tracked through commercial bank balance sheets, which follow the fundamental accounting identity:

$$\text{Total Assets} = \text{Total Liabilities} + \text{Net Worth}$$

- **Liabilities**: Customer checkable deposits are the primary liability, because the bank owes this money to depositors.
- **Assets**: Required reserves, excess reserves, loans, and securities (like government bonds) are all assets, because they represent value the bank owns or is owed by others.

When a new deposit is made, liabilities increase by the deposit amount, and assets increase by the same amount split between required and excess reserves. When the bank lends out excess reserves, excess reserves fall, and loans rise by the same amount (keeping total assets equal to liabilities), while the new loan creates a new deposit, increasing the money supply.

**Worked example:** Maple Street Bank receives a new \$5,000 deposit, with a required reserve ratio of 20%. Show the change in Maple Street Bank’s balance sheet (a) immediately after the deposit, before lending, and (b) after lending all excess reserves.

1. **Part (a): After deposit, before lending**
2. | Assets | Change in Value | Liabilities | Change in Value |
| --- | --- | --- | --- |
| Required Reserves | +\$1,000 | Deposits | +\$5,000 |
| Excess Reserves | +\$4,000 |  |  |
| *Total* | **+\$5,000** | *Total* | **+\$5,000** |
3. The balance sheet balances, with total assets equal to total liabilities.
4. **Part (b): After lending all excess reserves**
5. | Assets | Change in Value | Liabilities | Change in Value |
| --- | --- | --- | --- |
| Required Reserves | +\$1,000 | Deposits | +\$5,000 |
| Loans | +\$4,000 |  |  |
| *Total* | **+\$5,000** | *Total* | **+\$5,000** |
6. The bank eliminated all excess reserves by issuing a \$4,000 loan, which created \$4,000 of new money in the money supply. The loan will then be deposited in another bank to continue the expansion process.

> **Exam tip:** AP graders always check that balance sheets are balanced—if your total assets do not equal total liabilities, you will lose points even if your individual numbers are correct.

## AP-Style Concept Check

**Check your understanding**

Test your understanding with this AP-style multiple choice question:

1. The required reserve ratio is 12%. Banks lend out all excess reserves, and the public holds no currency. If the central bank injects \$240,000 of new reserves into the banking system, what is the total change in the M1 money supply?

   - A) \$28,800
   - B) \$2,000,000
   - C) \$1,760,000
   - D) \$2,240,000

   *Answer:* B) \$2,000,000

   *Why:* Correct. The simple multiplier is $1/0.12 \approx 8.333$, so total change is $240,000 \times 8.333 = \$2,000,000$. Distractor C is the amount of new money created by commercial banks (subtracting the initial injection), which was not asked for here.

## Common pitfalls

- **Wrong:** Automatically subtract the initial reserve injection from the total change in money supply, even when the question asks for total change.
  - Why it fails: Students memorize that commercial banks create "new money" equal to total deposits minus the initial injection, so they subtract it by default.
  - Correct: Read the question carefully: subtract the initial injection only if it asks for *new money created by commercial banks*; leave it in if it asks for total change in the money supply.
- **Wrong:** Using the simple money multiplier $1/rr$ when the problem states banks hold excess reserves or the public holds currency.
  - Why it fails: The simple multiplier is easier to calculate, so students default to it even when leakages are explicitly given.
  - Correct: Check for any mention of excess reserves or currency holdings; if they exist, use the adjusted money multiplier formula.
- **Wrong:** Classifying loans as liabilities on a bank balance sheet.
  - Why it fails: Students confuse "loans the bank has issued" with "money the bank owes", thinking loans are liabilities.
  - Correct: Remember: anything the bank owns or is owed is an asset (reserves, loans, bonds); anything the bank owes to customers is a liability (deposits).
- **Wrong:** Claiming money creation is only done by the central bank.
  - Why it fails: Popular media conflates base money creation with broad money creation.
  - Correct: On the exam, explicitly distinguish between central bank creation of monetary base and commercial bank creation of broad money via lending.
- **Wrong:** Calculating the money multiplier as $rr$ instead of $1/rr$, or swapping the numerator and denominator in the adjusted multiplier.
  - Why it fails: Students mix up the relationship between reserve requirements and the multiplier.
  - Correct: Before finalizing your calculation, confirm direction: a higher required reserve ratio reduces the multiplier, so $rr$ must be in the denominator.
- **Wrong:** Counting a transfer of deposits between two existing banks as a change in total reserves for the system.
  - Why it fails: Students assume any new deposit to a single bank is new to the whole system.
  - Correct: Only deposits from new central bank reserves or converted from public currency count as new reserves for the entire banking system.

## Cheatsheet

| Category | Formula | Notes |
| --- | --- | --- |
| Required Reserves | $RR = rr \times D$ | $rr$ = required reserve ratio, $D$ = total checkable deposits |
| Excess Reserves | $ER = \text{Total Reserves} - RR$ | Excess reserves = maximum amount a bank can lend out |
| Simple Money Multiplier | $mm_s = \frac{1}{rr}$ | Use only when no excess reserves and no currency leakage |
| Maximum Change in Total Deposits | $\Delta D = \Delta R \times mm$ | $\Delta R$ = change in total new reserves for the system |
| Adjusted Money Multiplier | $mm_a = \frac{1 + c}{rr + c + e}$ | $c$ = currency-deposit ratio, $e$ = excess reserve ratio; always smaller than $mm_s$ |
| Total Change in Money Supply | $\Delta M_s = \Delta MB \times mm_a$ | $\Delta MB$ = change in monetary base (new reserves) |
| New Money Created by Commercial Banks | $\Delta M_{\text{created}} = \Delta D - \Delta R$ | Subtract initial central bank injection for bank-created money |
| Bank Balance Sheet Identity | $\text{Total Assets} = \text{Total Liabilities} + \text{Net Worth}$ | Assets: reserves, loans, securities; Liabilities: customer deposits |

## What's next

Money creation is the foundational prerequisite for understanding how monetary policy affects aggregate demand, interest rates, and output in the macroeconomy. Next, you will apply the money multiplier concept to analyze how open market operations, reserve requirement changes, and discount lending by the central bank change the money supply and shift the money supply curve. Without a solid grasp of how money creation works, you will not be able to correctly predict the impact of contractionary or expansionary monetary policy on real GDP and the price level, which is a high-weight core FRQ topic. This topic also feeds into the bigger picture of how the financial sector connects to the aggregate economy, linking central bank actions to macroeconomic outcomes like unemployment and inflation.

- [Measures of Money Supply](https://www.owlsprep.com/study/ap-macroeconomics-u4-measures-of-money-supply/)
- [Money Market](https://www.owlsprep.com/study/ap-macroeconomics-u4-money-market/)
- [Central Bank and the Money Supply](https://www.owlsprep.com/study/ap-macroeconomics-u4-central-bank-and-the-money/)

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