Fractional Reserves and the Money Supply

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• The money supply is the total of reserves and bank deposits (including both checking accounts and saving accounts, called "M2").
• Because of fractional reserves, whatever sums banks are not required to keep as reserves can be lent. This money becomes deposits at another bank, which can then lend more money (up to 1 - R of it, where R is the reserve fraction) to firms, which then deposit it, and the process iterates.
• In a booming economy
  • banks expect all companies to pay back their loans, so they loan as much as the companies want, up to the limit imposed by the reserve requirement, and
  • companies expect to make money on all investments, so they borrow as much as the banks will lend.
• The equilibrium of this process is M2 = MB/R.

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