Loans out a portion of its reserves to individuals or firms who will then deposit the money in other bank accounts.
Theoretically, this process will until repeat until there are no excess reserves left.
The total amount of money created with a new bank deposit can be found using the deposit multiplier, which is the reciprocal of the reserve requirement ratio. Multiplying the deposit multiplier by the amount of the new deposit gives the total amount of money that may be created.
To understand the process of money creation, let us create a hypothetical system of banks. We will focus on two banks in this system: Anderson Bank and Brentwood Bank. Assume that all banks are required to hold reserves equal to 10% of their customer deposits. When a bank's excess reserves equal zero, it is loaned up.
Anderson and Brentwood both operate in a financial system with a 10% reserve requirement. Each has $10,000 in deposits and no excess reserves, so each has $9,000 in loans outstanding, and $10,000 in deposit balances held by customers.
Suppose a customer now deposits $1,000 in Anderson Bank. Anderson will loan out the maximum amount (90%) and hold the required 10% as reserves. There are now $11,000 in deposits in Anderson with $9,900 in loans outstanding.
The debtor takes her $900 loan and deposits it in Brentwood bank. Brentwood's deposits now total $10,900. Thus, you can see that total deposits were $20,000 before the initial $1,000 deposit, and are now $21,900 after. Even though only $1,000 were added to the system, the amount of money in the system increased by $1,900. The $900 in checkable deposits is new money; Anderson created it when it issued the $900 loan.
Mathematically, the relationship between reserve requirements (rr), deposits, and money creation is given by the deposit multiplier (m). The deposit multiplier is the ratio of the maximum possible change in deposits to the change in reserves. When banks in the economy have made the maximum legal amount of loans (zero excess reserves), the deposit multiplier is equal to the reciprocal of the required reserve ratio ($m=1/rr$).
In the above example the deposit multiplier is 1/0.1, or 10. Thus, with a required reserve ratio of 0.1, an increase in reserves of $1 can increase the money supply by up to $10 .