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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

In a simple fractional reserve banking system, banks hold reserves against deposits and lend out the rest. Which of the following best describes how this process leads to an expansion of the money supply?

Money expands because loans become new deposits elsewhere in the banking system. Each redeposit lets banks lend a further fraction, keeping only required reserves, so total deposits rise by a multiple of the original cash injection rather than staying constant.

  1. ALoans made by one bank are redeposited in the banking system, creating new deposits that can support further lendingCorrect
  2. BThe central bank prints a note for every loan that a commercial bank makes to a customer
  3. CBanks lend out only the exact amount of deposits received from savers, so total deposits remain unchanged
  4. DDepositors withdraw their funds in cash and spend them, which raises the stock of notes and coins held by banks
  5. Banks transfer reserves to the government, which spends them and so creates new deposits at the central bank

Explanation

When a bank lends, the borrower spends the proceeds and the recipient deposits them at a bank. That deposit supports further lending, so total deposits grow by a multiple of the initial reserves. The other options describe processes that do not create deposits through lending.

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