Regardless of what measure of the money supply is employed, we must first understand how our banking system operates to understand how the central bank controls the money supply. The key thing to recognize is that banks can create money by extending loans. If a bank loans you $1,000, you sign a legal agreement with the bank, and it simply opens an account in your name with a balance of $1,000. This $1,000 is now counted as part of the economy’s money supply: it has been created by this bank out of thin air!

When a bank creates money out of thin air like this, it is taking a chance, hoping that you and other depositors will conduct financial transactions by using checks rather than cash. If you wanted to withdraw the $1,000 in cash, it could be embarrassing for the bank. Because it created the $1,000 deposit out of thin air, it may not have $1,000 in cash to give you!

To guard against this kind of embarrassment, banks refrain from creating money (loans) in unlimited quantities. Most customers make transactions by writing checks so that banks are continually experiencing increases and decreases in deposit balances as checks clear, and increases and decreases in their vault cash as cash is deposited or withdrawn. They know from experience, however, that the amount of cash they must have on hand to deal with withdrawals of cash is a small fraction of total deposits, and so they limit the money they create (loans they make) to ensure that their reserves of cash are at least this fraction of total deposits.

The implication of all this for the money supply is best explained by means of an example. Suppose banks figure their cash requirements should be 5 percent of total deposits. If the banking system’s cash holdings are $40 billion, then the banks will increase loans until the amount of deposits, and thus the money supply, is $800 billion. (Five percent of $800 billion is $40 billion.) Because the central bank (the Fed) creates cash, any balances in the commercial banks’ accounts with the Fed are just as good as cash. This fact implies that the reserves held by banks to handle possible cash disbursements can be either cash or balances in their accounts at the central bank. (Such balances are called claims on the central bank.) The money supply is thus a multiple of these reserves, which are controlled by the central bank. Because such reserves are a fraction of the total money supply, this banking system is called a fractional-reserve banking system.

There is an obvious danger inherent in such a banking system. Because a smaller percentage of reserves means a greater quantity of loans and therefore more profits, there is a temptation for banks to underestimate the fraction of reserves they should hold. This increases the chances of being unable to meet requests for cash, with the consequent financial ruin of the bank should depositors panic and create a run on that bank. Government regulation of banks, including deposit insurance and the setting of a reserve requirement, arose because of such banking disasters and because the government wanted to be able to control the total amount of money circulating in the economy to affect the pace of economic activity.