An article in the Wall Street Journal noted that for a small community bank in upstate New York, “only 42% of deposits were lent out, compared with 69% at Bank of America.”
Source: Rachel Louise Ensign and Coulter Jones, “The Problem for Small Town Banks: People Want High Tech Services,” Wall Street Journal, March 2, 2019.
Does the fraction of their deposits that banks lend out have anything to do with the size of the money supply? Briefly explain.
A.
Yes, the larger the fraction of deposits that banks lend out, the smaller the money supply will be, and vice versa.
B.
No, the size of the money supply is generally determined by other economic variables, such as the interest rate.
C.
Yes, the larger the fraction of deposits that banks lend out, the larger the money supply will be, and vice versa.
D.
No, the small size of community banks makes them unable to affect the money supply, regardless of the percentage of deposits lent out.
The correct answer and explanation is :
Correct Answer: C. Yes, the larger the fraction of deposits that banks lend out, the larger the money supply will be, and vice versa.
Explanation:
The fraction of deposits that banks lend out is directly tied to the money multiplier and the process of money creation in the banking system. This relationship is central to how modern fractional reserve banking works.
When banks receive deposits, they are required by the central bank (in the U.S., the Federal Reserve) to hold a fraction of those deposits as reserves—either in their vaults or on deposit with the central bank. The remainder can be lent out. The portion that is lent out becomes new deposits in the banking system when spent and redeposited, and those new deposits can then be lent out again, and so on. This process increases the overall money supply, which includes currency in circulation plus demand deposits and other liquid assets.
The more a bank lends out of its deposits (within regulatory limits), the more it contributes to this chain reaction of money creation. This is why large banks like Bank of America, which lend a higher percentage of their deposits (69% in this case), have a greater multiplying effect on the money supply than small community banks that lend less (like the 42% cited).
In this context, a lower loan-to-deposit ratio means fewer funds are circulating through the economy, reducing the pace of money creation. Conversely, a higher loan-to-deposit ratio can significantly increase the money supply, assuming there’s demand for loans and banks are confident in lending.
Therefore, the size of the money supply is affected by how much of their deposits banks choose to lend, making answer C the most accurate choice.