Discuss how a single bank creates money. What is the limit to which a single bank can add to the money supply? By how much can an entire banking system add to the money supply?

Answer 1

A single bank is limited in its money creating ability dollar for dollar with what it has as excess reserves. Excess reserves equal actual reserves minus required reserves. Required reserves are calculated by multiplying the required reserve ratio (arbitrarily determined by the Fed) by the bank's demand deposit liabilities.

On the other hand, an entire banking system can loan out and add to the money supply by a multiple of what it has as excess reserves. This is because when loans are made, many of these funds find their way back onto the banking system by being deposited into other banks. These other banks can re-loan out a fraction of these funds (that fraction which is not held as required reserves). The process continues giving rise to a multiple increase in the money supply. To calculate the extent to which the money supply increases, one needs to multiply the initial amount of excess reserves in the banking system by the money multiplier. The money multiplier equals the reciprocal of the required reserve ratio.