27.4 How Banks Create Money
2 min read•june 24, 2024
Banks are money-making machines, literally! They create money through lending, using a system called . This process allows banks to lend out a portion of deposits, creating new money in borrowers' accounts.
The money creation process has a multiplier effect, amplifying the initial deposit. While this system stimulates economic growth, it also carries risks like and . Central banks play a crucial role in managing these risks and the overall .
How Banks Create Money
Fractional Reserve Lending
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- Banks create money through lending
- Loans create deposits in borrower's account, new money that didn't previously exist
- Example: Bank lends 100,000 deposit in the borrower's account
- Fractional reserve system enables lending a portion of deposits
- Banks keep a fraction (reserve requirement) of deposits on hand
- Remaining fraction can be lent out
- Example: 10% reserve requirement, 900 to be lent out
- amplifies initial deposit
- Borrowed money is spent, becomes a deposit in another bank
- Receiving bank lends a portion of new deposit, creating more money
- Example: 10,000 in total deposits
T-Account Balance Sheets
- T-accounts track bank and
- Assets on left: Loans (money lent), Reserves (cash held)
- Liabilities on right: Deposits (customer deposits)
- T-account must balance: Assets = Liabilities
- Example T-account:
Assets | Liabilities ----------|------------ Loans | Deposits Reserves | - Sample entries:
- 100,000, Deposits +$100,000
- 10,000, Deposits +$10,000
Risks and Benefits
- Benefits of bank money creation:
- Increases money supply, stimulates economic growth
- Enables borrowers to invest or consume
- Banks earn interest income on loans
- Risks of bank money creation:
- Excessive lending can cause inflation (money supply grows faster than goods and services)
- Risky loans may lead to defaults and bank failures
- Fractional reserves make banks vulnerable to "runs" (many simultaneous withdrawals)
- Central banks manage money supply and risks:
- Reserve requirements: Fraction of deposits held in reserves
- Open market operations: Buying or selling government securities influences money supply
- Discount rate: Interest rate for banks borrowing from central bank
Key Terms to Review (23)
Assets: Assets are resources owned by an individual or organization that have economic value and can be converted into cash. They are the building blocks of a balance sheet and are essential for understanding a company's financial health and its ability to generate future cash flows.
Bank Lending: Bank lending refers to the process by which banks provide loans and credit to individuals, businesses, and other entities. It is a crucial component of the banking system and the broader economy, as it enables the flow of capital and facilitates economic growth and development.
Bank Regulation: Bank regulation refers to the laws, rules, and oversight mechanisms put in place by government agencies to control and monitor the activities of banks and other financial institutions. It aims to ensure the stability, safety, and soundness of the banking system, protect consumers, and prevent financial crises.
Bank Runs: A bank run is a situation where a large number of bank customers withdraw their deposits from a financial institution due to a fear that the bank may become insolvent and be unable to meet its obligations. This can lead to the collapse of the bank as it becomes unable to cover the withdrawals, creating a self-fulfilling prophecy of the bank's failure.
Capital Adequacy Ratios: Capital adequacy ratios are regulatory measures that assess the financial strength and stability of banks by evaluating the relationship between a bank's capital and its risk-weighted assets. These ratios serve as a crucial tool in bank regulation, ensuring that banks maintain sufficient capital to absorb potential losses and mitigate financial risks.
Credit Creation: Credit creation is the process by which banks, through their lending activities, generate new money in the form of bank deposits. This is a crucial mechanism in the fractional reserve banking system, where banks can lend out a portion of their deposits, thereby expanding the overall money supply in the economy.
Deposit Expansion: Deposit expansion is the process by which banks can create new money through the fractional reserve banking system. It occurs when banks lend out a portion of the deposits they hold, allowing those funds to be re-deposited and lent out again, leading to an increase in the total money supply.
Discount Window: The discount window is a lending facility operated by the central bank, such as the Federal Reserve in the United States, that allows eligible financial institutions to borrow money from the central bank, typically on a short-term basis, to meet temporary liquidity needs. This mechanism serves as a crucial tool for central banks to implement monetary policy and provide stability to the financial system.
Equity: Equity refers to the fair and impartial treatment of all individuals, ensuring that everyone has access to the same opportunities and resources, regardless of their personal characteristics or background. In the context of banking and money creation, equity is a crucial concept that underpins the fair and responsible distribution of financial services and resources.
European Central Bank: The European Central Bank (ECB) is the central banking system of the European Union (EU). It is responsible for the monetary policy of the 19 EU member states which have adopted the euro as their official currency, known as the eurozone.
Federal Reserve: The Federal Reserve, commonly referred to as the Fed, is the central banking system of the United States. It is responsible for conducting monetary policy, supervising banks, maintaining financial system stability, and providing banking services to the government. The Fed's actions and decisions have far-reaching implications for the overall economy, influencing factors such as inflation, employment, and economic growth.
Fractional Reserve Banking: Fractional reserve banking is a banking system where banks hold only a fraction of their customers' deposits as reserves, and use the rest to make loans. This practice allows banks to expand the money supply and create new money, but also introduces the risk of bank runs and financial instability.
Inflation: Inflation is the sustained increase in the general price level of goods and services in an economy over time. It represents a decline in the purchasing power of a currency, as each unit of currency can buy fewer goods and services. Inflation is a crucial macroeconomic concept that affects various aspects of the economy, including households, businesses, and government policies.
Lender of Last Resort: The lender of last resort is a financial institution, typically a central bank, that provides emergency funding to other banks or financial institutions when they are unable to obtain sufficient liquidity from other sources. This role is crucial in maintaining financial stability and preventing a systemic crisis.
Liabilities: Liabilities are a company's financial obligations or debts that it owes to other parties. They represent the claims that creditors have on a company's assets and must be paid off or otherwise satisfied. Liabilities are a crucial component in understanding a company's financial health and its ability to meet its financial commitments.
Liquidity: Liquidity refers to the ease and speed with which an asset can be converted into cash without significant loss in value. It is a critical concept in the context of financial markets, household financial decisions, and monetary policy.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to control the money supply and influence economic conditions. It is a crucial tool used by governments to achieve macroeconomic objectives such as price stability, full employment, and economic growth.
Money Multiplier: The money multiplier is a concept that explains how a change in the monetary base, controlled by the central bank, can lead to a larger change in the overall money supply in the economy. It demonstrates the ability of the banking system to create money through the fractional reserve system.
Money Supply: The money supply refers to the total amount of money available in an economy at a given time. It encompasses various forms of liquid assets that can be easily used as a medium of exchange, including currency, deposits, and other highly liquid instruments. The money supply is a crucial economic indicator that influences economic activity, inflation, and the effectiveness of monetary policy.
Money Velocity: Money velocity refers to the rate at which money circulates through the economy. It measures the frequency at which one unit of currency is used to purchase goods and services within a given time period. Money velocity is a crucial concept in understanding how changes in the money supply can impact economic activity and inflation.
Quantity Theory of Money: The quantity theory of money is an economic principle that states the general price level of goods and services is directly proportional to the amount of money in circulation. It explains the relationship between the money supply, the velocity of money, and the price level in an economy.
Reserve Ratio: The reserve ratio, also known as the reserve requirement, is a central banking regulation that sets the minimum amount of reserves that a commercial bank must hold relative to its customer deposits. This ratio is a key tool used by central banks to control the money supply and influence the lending and borrowing activities of the banking system.
T-account Balance Sheets: A T-account balance sheet is a visual representation of a company's assets, liabilities, and equity, organized in the shape of the letter 'T'. It provides a clear and concise way to track the changes in a company's financial position over time, making it a fundamental tool in understanding how banks create money.