Deposits and Reserves
In 2010, banks had some $7 trillion on deposit. Deposits at banks are used to create money and enhance economic activity. When you deposit money at a bank, the bank is required to keep some in reserve and is allowed to loan the rest. The Federal Reserve determines this reserve requirement. Even without the Federal Reserve's requirements, banks would still keep money on hand to ensure that checks, automated bank machine withdrawals and withdrawals at the teller's window are easily accommodated.
To understand how bank deposits create money, consider this simplified example. You deposit $10,000. The bank keeps 3 percent, or $300, in the teller tills. It can then loan out the remaining $9,700, which it does. The person borrowing the money purchases something, and the seller deposits the money back into the bank. The bank keeps 3 percent of this in the teller tills, and can loan out the remaining $9,409. This process will continue, and in this example your $10,000 of money creates over $300,000.
Bank Runs And Other Dangers
The same process that increases the money supply can lead to its shrinkage. The extreme case of this is known as a bank run. Bank runs have occurred in the United States roughly every 20 years since 1819. Bank runs happen when depositors feel panicked about the safety of their deposits. They go to the bank to take out their money without the intention of spending it or depositing it elsewhere. When this happens on a very large scale, banks have difficulty coming up with the cash and this heightens the sense of panic. To raise cash, banks have to prematurely call in the loans they made, and this can drive businesses to bankruptcy. In turn, this can in the worst of cases, lead to an economic depression.
The effects of bank runs are catastrophic, yet there are significant benefits to a banking system that creates money. Consequently, government policy makers continually monitor and regulate the banking sector to ensure depositors are protected. Perhaps the most visible sign of this is the Federal Deposit Insurance Corporation, which provides guarantees to bank deposits.