The Birth of Banking (IV) - Practice of Fractional Reserve

To understand the power of these three innovations, first-year MBA students at Harvard Business School play a simplified money game. It begins with a notional central bank paying the professor $100 on behalf of the government, for which he has done some not very lucrative consulting. The professor takes the banknotes to a bank notionally operated by one of his students and deposits them there, receiving a deposit slip. Assuming, for the sake of simplicity, that this bank operates a 10 per cent reserve ratio (that is, it wishes to maintain the ratio of its reserves to its total liabilities at 10 per cent), it deposits $ 10 with the central bank and lends the other $90 to one of its clients. While the client decides what to do with his loan, he deposits the money in another bank. This bank also has a 10 per cent reserve rule, so it deposit $9 at the central bank and lends out the remaining $81 to another of its clients. After several more rounds, the professor asks the class to compute the increase in the supply of money. This allows him to introduce two of the core definitions of modern monetary theory: M0 (also known as the monetary base or high-powered money), which is equal to the total liabilities of the central bank, that is, cash plus the reserves of private sector banks on deposit at the central bank; and M1 (also known as narrow money), which is equal to cash in circulation plus demand or 'sight' deposits. By the time money has been deposited at three different student banks, M0 is equal to $100 but M1 is equal to $ 271 ($100 + $90 + $81), neatly illustrating, albeit in a highly simplified way, how modern fractional reserve banking allows the creation of credit and hence of money.