pcecon.com Class Notes
by

To see where our money comes from, let's tell a little story.
Suppose Al Addin meets a genie, who grants him one wish. Al wishes for a million dollars, and the genie grants the wish, with no pesky IRS or legal entanglements
Al Addin gets $1,000,000 cash (created by the genie)
Al deposits his $1,000,000 in a bank. His deposit is now the form of his money, since bank accounts are money.
Al's bank has $1,000,000 in increased reserves (cash in a bank is no longer money; it becomes bank reserves).
Al's bank has $1,000,000 more in reserves and $1,000,000 in deposits.
If the required reserve ratio is 10% Al's bank only has to keep .1x$1,000,000 as reserve on his deposit. Al's bank only needs to keep $100,000 on hand to back up his deposit. $100,000 is required reserves;
actual reserves - required reserves = excess reserves
$1,000,000 -$100,000 = $900,000
Since Al's bank has $900,000 more reserves than it needs to back up Al's deposits, it will lend the excess out.
Al's bank loans out $900,000 to Bugs; the bank creates an account with $900,000 in it.
Bugs spends it on a business. Porky sells the business to Bugs, and Porky deposits money in his account at his bank in the form of a check. Notice that the total amount of money created by the genie and the bank is now $1,900,000
The Fed (the Federal Reserve Bank or its agent) takes $900,000 out of Al's and Bugs's bank's account at the Fed and puts it into the Fed account of Porky's bank. This reduces the actual reserves of Al's and Bugs's bank, but increases the actual reserves of Porky's bank by $900,000.
If the required reserve ratio is 10% Porky's bank only has to keep .1x$900,000 as reserve on Porky's deposit, so Porky's bank only needs to keep $90,000 on hand to back up his deposit. $90,000 is required reserves;
actual reserves - required reserves = excess reserves
$900,000 -$90,000 = $810,000
Porky's bank has $810,000 more reserves than it needs so it loans out $810,000 to Daffy; the bank creates an account with $810,000 in it.
Daffy spends it on a house. Elmer sells the house to Daffy, and Elmer deposits money in his account at him bank in the form of a check. Notice that the total amount of money created by the genie and the two banks is now $2,710,000
The Fed takes $810,000 out of Porky's and Daffy's bank's account at the Fed and puts it into the Fed account of Elmer's bank. This reduces the actual reserves of Porky's and Daffy's bank, but increases the actual reserves of Elmer's bank by $810,000.
If the required reserve ratio is 10% Elmer's bank only has to keep .1x$810,000 as reserve on his deposit. Elmer's bank only needs to keep $81,000 on hand to back up his deposit. $81,000 is required reserves;
actual reserves - required reserves = excess reserves
$810,000 -$81,000 = $729,000
That bank creates a loan, creating $729,000 more new money, bringing the total up to $3,439,000 since Al met the genie.

This process keeps going, with banks getting deposits and reserves. The reserves each bank gets will exceed the amount it needs to back up the deposits, so each bank will make a loan and, in so doing, create additional bank deposits (all of which are money),