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The table you see shows the hypothetical assets and liabilities of a bank with $100,000 in new deposits and a 20% required reserve ratio. Initially, all $100,000 is in reserves: $20,000 required and $80,000 excess reserves.

Suppose the bank uses its excess reserves to buy $40,000 worth of bonds and make $40,000 in loans. How does this affect the money supply? Does is cause it to increase, decrease, or does it have no effect?

The bank still has exactly $100,000 in assets, but now they are in the form of reserves, loans, and bonds. The $40,000 loan will be made in the form of a check that will most likely be deposited in another bank. The borrower can spend that $40,000, just like our original depositor still has $100,000 that she can spend -- there is now a total of $140,000 that can be spent, an increase of $40,000 in the money supply!
     The bank where the borrower deposited the money he or she borrowed will put $8,000 (20% of $40,000) into required reserves and has a choice about what to do with the remaining $32,000 of excess reserves. If it loans out the excess reserves, the money supply will increase. If it leaves the money in reserves or puts the money into bonds, the money supply will not increase.

Now suppose that the Fed lowers the reserve ratio to 10%. Does the money supply increase, decrease, or have no change?

Lowering the required reserve ratio results in the bank having an extra $10,000 in excess reserves that can potentially be loaned out. If any or all of the excess reserves are used to make loans, the money supply will increase.

Now suppose that the Fed, in an effort to increase the money supply, buys $30,000 worth of bonds from our bank. This increased demand for bonds will push their price up and the interest rate down. The money that the bank receives from the Fed in payment for the bonds is placed in the bank's excess reserves. Should the bank use this money for additional loans? Why or why not?

What will the bank do with these new excess reserves of $30,000? Well, since bond prices are now high, they will have an incentive to make new loans, thus increasing the money supply. Maybe the bank will even loan out the preexisting $10,000 in excess reserves that were not earning any interest!

Our bank is in pretty good shape -- it has $80,000 in outstanding loans that are earning interest and are being cycled through the banking system to create more loans and more money.

What, if in addition to buying bonds from our bank, the Fed also buys $50,000 worth of bonds from one of the bank's customers? Well, the customer will receive a check from the Fed, and in most cases, will deposit the $50,000 check in her checking account. Of course, $5,000 (10%) of this money must be put into her bank’s required reserves, but another $45,000 in excess reserves will be available to make new loans and increase the nation's money supply.

Suppose at this time the Fed decides that the money supply has grown a little too rapidly (inflation may become a threat). To slow down the increase, the Fed decides to sell some bonds to the bank. It entices the bank to buy, by lowering the bond prices and raising the interest rate that the bonds earn. The bank can use its excess reserves to buy $45,000 worth of bonds.

By buying bonds instead of making loans, the bank does not participate in a money creation process. The money supply growth has been slowed. Notice that, as always, the bank's assets and liabilities must equal one another.

One last exercise. Our bank has no excess reserves left with which to make new loans. Suppose a very good customer comes in hoping to borrow $10,000 at a very good interest rate ­ say 12%. Our bank checks with the Fed and finds that the discount rate is only 8%. Seeing a quick way to make a tidy profit, the bank borrows $10,000 at 8% from the Fed and re­lends it to the customer at 12%.

Notice that the bank's required reserves do not change! Required reserves are only necessary as a partial offset on deposits, and the Fed loan is not a deposit -- it goes straight into the bank's reserves. The bank is free to loan out the entire $10,000, and this will ultimately result in an increase in the money supply.