To illustrate how €1,000 of reserves can create €9,000 of deposits, we'll assume a reserve requirement of 10% and a single bank in the Eurozone.
Step-by-step illustration
- Initial Deposit: A customer deposits €1,000 into the bank.
- Reserve Requirement: The reserve requirement set by the European Central Bank (ECB) is 10% of total deposits.
- Excess Reserves: The bank must keep 10% of the initial deposit as reserves, which is €100 (10% of €1,000). This leaves the bank with €900 in excess reserves that can be used for lending.
- Credit Creation: The bank lends out the €900 to a borrower.
- New Deposit: The borrower receives the €900 loan, which is then deposited into another bank (possibly the same bank, but for the sake of simplicity, let's assume it's a different bank).
- New Reserve: The receiving bank must hold 10% of the new deposit as a reserve. Since the new deposit is €900, the reserve is €90 (10% of €900).
- Repeat: The process can continue as long as there are excess reserves. When the receiving bank lends the remaining €810 (€900 - €90) to another borrower, that amount becomes a new deposit, and the cycle continues.
To summarise the changes after each round of lending and deposit:
Round 1:
Initial Deposit: €1,000
Excess Reserves: €900 (€1,000 - €100)
New Loan: €900
Total Deposits: €1,900 (€1,000 + €900)
New Reserve: €190 (10% of €1,900)
Round 2:
New Deposit: €900 (from the loan in Round 1)
Excess Reserves: €810 (€900 - €90)
New Loan: €810
Total Deposits: €2,710 (€1,900 + €810)
New Reserve: €271 (10% of €2,710)
Round 3:
New Deposit: €810 (from the loan in Round 2)
Excess Reserves: €729 (€810 - €81)
New Loan: €729
Total Deposits: €3,439 (€2,710 + €729)
New Reserve: €344 (10% of €3,439)
This process can continue, and after several rounds, the deposits will reach approximately €9,000. As you can see, a single €1,000 deposit has resulted in a significant increase in total deposits through the creation of credit by the banking system. It's important to note that the process may not reach exactly €9,000 due to rounding and other factors, but this illustration demonstrates the idea of how banks can create credit and expand the money supply in the Eurozone.