A fractional reserve system requires a bank to hold as idle cash only a fraction of a deposit it receives. Within the framework of a fractional reserve rule, monetary expansion is accomplished when holders of cash assets decide to exchange these cash assets for demand deposits or bank credit. Creating for a cash asset holder a demand deposit does not in itself expand the money supply as the increase in the money supply occasioned by the creation of the demand deposit is exactly counterbalanced by an equal reduction of currency in circulation. While the initial deposit changes only the composition but not the size of the money supply, the stage is set for monetary expansion. This process of monetary expansion continues as the loan is spent and its proceeds are redeposited in another bank.
Monetary expansion occurs also in consequence of expansionary federal reserve credit policy.
Financing a deficit by selling bonds to the federal reserve illustrates such an expansionary policy. What the above description of commercial bank and federal reserve credit expansion indicates is that monetary expansion profoundly impacts on the relative price structure. Farmers, consumers and businessmen compete for the available credit. Each of these groups is by no means homogeneous. The spending pattern of the recipients of the bank credit impact upon the relative price structure.