The banks whose operations mainly influence the money supply are called commercial bunks, because in the early days, most bank borrowers were engaged in commerce rather than manufacturing. These banks perform a variety of service functions. My bank receives my paycheck every month, allows me to draw checks on the account, and sends me a statement at the end of the month. But this is an unexciting and not very profitable operation. The lifeblood of commercial banking is lending — sizing up would-be borrowers and advancing them money at a price.
What happens when a bank makes a loan? A company applies for a loan of $1 million, and the bank agrees. The company gives the bank a piece of paper promising to repay the loan after, say, six months. The bank gives the company an addition of $1 million to its checking account. Money supply increases. When the time for payment comes round, unless the loan is renewed, repayment is made by deducting $1 million from the company's checking account. The central principle is simple: Making a loan creates money, while repaying a loan extinguishes money.
This looks very easy and profitable — the bank just creates money by a stroke of the pen. So why not create as much money as possible? The difficulty with this idea is that when people and companies have checking accounts, they are likely to use them. In addition to writing checks, they may want to draw out part of their deposit in cash. So a bank must have some cash in the vault, and a place where it can go for more cash if necessary. In short, a bank must have reserves.
What, concretely, are reserves? They consist partly of currency (bills and coins) held in the bank to meet day-to-day requirements. Most reserves, however, take the form of deposits (checking accounts) with the Federal Reserve System. All national banks must be members of the system, and the Fed requires them to carry reserves equal to a specified percentage of their deposits. In addition, under the Monetary Control Act of 1980, all banks and savings institutions, whether members or non-members, must carry a certain percentage of their deposits as reserves and must report on this regularly to the Fed. This "certain percentage", the minimum legal reserves-to-demand-deposits ratio, is usually called the reserve requirement.
If the volume of their demand deposits is already so large that the banks have just enough reserves to satisfy the reserve requirement, they can create no demand deposits, for to do so would cause the reserves-to-demand-deposits ratio to fall below the minimum legal level. On the other hand, if the banks have more than enough reserves to meet the reserve requirement, they can expand their loans and investments by creating additional demand deposits.
Macro Economics: Analysis and Policy by Lloyd G. Reynolds, Sterling Professor of Economics, Yale University. Published by IRWIN, Homewood IL 60430.
The Economics of Prosperity