Many people are accustomed to the idea that banks magically print money and cause inflation. People wonder, “Hey, why can’t I do that?” Well, the answer is you can’t because nobody can, not even commercial banks.
In a fractional reserve banking system like the one we have, commercial banks can only lend an amount equal to their assets, minus whatever reserve requirement has been put in place by the government. In the case of the United States, thanks to the economic situation, that requirement has been made zero, though it was ten percent before the crisis.
Say you own a bank with $100 million in assets. This means you can only lend $100 million, or $90 million a few months ago. You are legally required to keep a reserve equal to zero, or previously ten percent of your deposits.
You may be wondering how the money supply increases if commercial banks can only lend an amount equal, or less than the amount it has in deposits.
Well, if your bank with $100 million lends $90 million to the government, and the government spends it, a portion of that money can find its way back to the bank in the form of deposits, say $50 million. The bank then lends $45 million of that back to the government, and then the cycle repeats. If every dollar the government spends ends up as deposits, commercial banks can create a maximum of $1,000 million, or the amount of initial deposits multiplied by the ratio that one bears to the reserve requirement, which in this case is ten. This is called the money multiplier, and it both limits and delimits the amount of money banks can create.
There is one thing to note, however, and that’s that loans must be paid back, so really in the long-term, banks can’t create money unless the government continues to borrow. In practice, the amount of money creation is really controlled by the demand for credit (the demand for loans). Another factor is that banks hold what are called excess reserves, or in other words a larger reserve than they required to hold, which further limits credit (money) creation.
The other source of money creation is better known: Say Hello to the Federal Reserve.
The Federal Reserve is the central bank of the United States, in effect a publically run corporation with special powers. The Federal Reserve was created in 1913 by the Federal Reserve Act, which was signed by Woodrow Wilson.
The Federal Reserve has the authority to buy commercial bank securities, which in the short-term increases the assets a bank has, allowing them to increase lending. This is called quantitative easing. Of course, in the long-term, the Federal Reserve is paid back this amount with interest.
Those are the two major ways the money supply is increased. In recent years, the policy of the Federal Reserve has been to maintain a steady rate of inflation at around 2%. To sum things up, the federal reserve, federal government, and commercial banks collaborate in a way to regulate the money supply to maximize economic output and stabilize prices.
Now you have an elementary understanding of fractional reserve banking!