All other things being equal, a bank can create money by lending money it does not have: it takes advantage of the fact that its depositors only withdraw a fraction λ of their assets to lend the remaining amount. This mechanism helps us understand an initial limitation on banks’ money-creation power: the more depositors withdraw money or carry out transactions with customers of other banks (or with the Treasury, which generally has an account with the central bank), the more the bank will experience « leakage » in its deposits. The factors at work in this scenario correspond to what are commonly referred to as autonomous factors, and, from this perspective, the bank in question will need to have sufficient reserves to respond to these factors. Institutional factors are also at work: the central bank requires banks to set aside part of their reserves as « required reserves, » which reduces the amount of reserves available to respond to autonomous factors.
From this perspective, we can immediately see a theoretical limit emerging in terms of the bank’s ability to distribute credit and therefore to create money.[1].
The reasoning proposed here remains theoretical, and allows us to understand the potential consequences of an increase in the reserve requirement ratio in a country (all other things being equal).
Julien P.
[1]For there to be a real theoretical limit, it must also be assumed that a bank cannot have an overdraft with the central bank or obtain refinancing from it as it wishes (this is the assumption adopted for simplicity in the credit multiplier model, although it is not accurate in practice).
