One of the most interesting industries in the world is the world of banking.  Banking is a business with the purpose of making more money from money given to them to hold.  The Banks make money by giving out Loans and charging interest for them and investing in numerous areas including the stock market and government securities.  However one of the side effects of the many loans that banks give is that buy granting such loans they increase the money supply.  In this way the banks essentially create new money.  This effect is not entirely a good one.  When the money supply is increased too much it may create inflation.  For this reason we have the Federal Reserve System whose job it is to expand or contract the money supply when it is appropriate.

When a Bank recieves a deposit from a customer it is only required by the Federal Reserve to keep a certain amount of that deposit in the bank.  As previously stated, the rest the bank is free to both give out loans, make investments and buy government securities.  Here is an Example of how the Federal Reserve bank encourages expansion of the money supply by buying back goverment Securities from the bank:

Where R is the Reserve Ration, L is loans, G is Government Securities and D is Deposits

Assets	Liabilities
R 20	D 100
L 40
G 40

The Reserve Ratio is 20% , the Fed now buys back 10 government securities.

Assets	Liabilities
R 30	D 100
L 40
G 30

In order to maximize profits the bank will then only keep the required reserve ration of 20% and loan out all the rest. thus:

Assets	Liabilities
R 20	D 100
L 50
G 30

The Loan amount available for the Bank has now increased by 10 allowing for larger loans to be given out and thus creating more money on it's return due to interest.

In the second bank, the difference is in Deposits is plus 10 because of the increase in Loans in the previous cycle.

Assets	Liabilities
R 20	D 100
L 40
G 40

The next step shows the increase in D

Assets	Liabilities
R 30	D 110
L 40
G 40

In order to keep profits maximized the banks will decrease R until it is at the 20% of D.

Assets	Liabilities
R 22	D 110
L 48
G 40

The increase in Loans through the second bank is 8 this time.  So in Bank three we begin at:

Assets	Liabilities
R 20	D 100
L 40
G 40

The increase of D is equal to the previous increase of L, so we increase deposits by 8.

Assets	Liabilities
R 28	D 108
L 40
G 40

Again the bank must adjust its reserve in order to maximize profits.

Assets	Liabilities
R 21.6	D 108
L 46.4
G 40

However, the economy will not always need a boost.  Sometimes rapid growth and inflation leads to extreme rises in the Cost of Living.  In order to prevent this, the Federal Reserve will sometimes attempt to contract the moeny supply.  The Contraction is essentially a minus expansion. So rather than buying back government securities they will sell more in order to decrease loans.

Assets	Liablities
R 20	D 100
L 40
G 40

The government then sells government securities:

Assets	Liabilites
R 10	D 100
L 40
G 50

However the bank must keep the required reserve ratio of 20%

Assets	Liabilities
R 20	D 100
L 30
G 50

The Loan amount has now decreased by 10 thus contracting the money supply in the next step.

The cycle then continues in Bank 2, as the Initial Position 10 withdrawl to the Bank 1 loan:

Assets	Liabilities
R 20	D 100
L 40
G 40

Because the previous Loan decreased by 10 the Deposit total in the second bank will now be 10 less as well

Assets	Liabilities
R 10	D 90
L 40
G 40

Again the bank must adjust to keep the required reserve ratio, thus continuing the contraction of the money supply.

Assets	Liabilities
R 18	D 90
L 32
G 40

Karl E. Case, and Ray C. Fair.  Principles of Macroeconomics, Seventh Edition.  Upper Saddle River, NJ: Pearson Prentice Hall, 2003.