Final answer:
The money supply expansion in an economy is a result of the process where banks loan out their reserves, which are then redeposited and reloaned by other banks. This cycle is facilitated by the money multiplier effect, which determines the potential increase in total money supply.
Step-by-step explanation:
Understanding Money Supply Expansion in Banking
The money supply in an economy can grow through the actions of banks and the lending process, illustrating a close tie between money and credit in the financial system. The original reserves held by banks are the only part of the money supply not generated through bank loans.
These reserves are repeatedly deposited and re-loaned across various financial institutions. A crucial element in this process is the money multiplier, which indicates how much the money supply can potentially increase based on the excess reserves banks hold.
When a bank, such as Singleton Bank, loans out its excess reserves to a customer like Hank's Auto Supply, and these funds are then deposited in another bank like First National Bank, the other bank is then able to loan out a portion of these deposits, minus its required reserves.
This sequence creates a multiplier effect as every loan turns into a deposit at another bank, which then becomes a loan again, and so on.
Thus, if all banks continuously loan out their excess reserves, the total money supply exponentially expands, leading to a cumulative increase in the money supply across the entire banking system.