When money is deposited in a bank, the bank is able to use that money to increase the money supply by much more than just the sum that is initially deposited. It is able to do this because it can take the deposit, hold the required reserves, and loan the rest out.
When the bank took in the $100,000, it could hold $4,000 and loan out $96,000 as show in round 1 below. The $96,000 that it loans will then be deposited in a bank somewhere and 4% of it will be kept as reserves while the rest is loaned out. This is show in round 2. The process goes on and on.
- Round 1
New deposits 100,000
New reserves 4,000
- Round 2
New deposits 96,000
- Round 3
New deposits 92,160
New loans 88,473.60
The exact amount that the money supply will go up can be found by using a money multiplier. The formula is
Money multiplier = 1/required reserve ratio.
Here, we know the required reserve ratio is .04. Therefore
Money multiplier = 1/.04 = 25.
This means that the initial deposit will increase the money supply by 25 times its own value. The initial deposit was $100,000. Multiplied by 25, that makes $2.5 million.
Thus, the bank can increase the money supply by $2.5 million by using the $100,000 deposit.