How Banks Create Money Through Loans

Money is created when banks lend. The rules of double-entry accounting dictate that when banks create a new loan asset, they must also create an equal and opposite liability, in the form of a new demand deposit. Banks can create money through the accounting they use when granting loans. The numbers you see when you check your account balance are actually just accounting entries on bank computers. These numbers are a “liability” or promissory note of your bank to you.

However, by using your debit card or online banking, you can spend these IOUs as if they were physical money. By creating these electronic notes, banks can effectively create a substitute for paper money. It's not just that most of the money is in the form of bank accounts. The banking system can literally create money through the process of making loans. The Federal Reserve creates money when it decides that the economy would benefit if it did.

It creates money not by printing currency, but by effectively adding funds to the money supply. There are two interesting things we will learn in this chapter. First, banks create money when they do their normal business of accepting deposits and making loans. When banks make loans, they create money. Remember from chapter 12 that money (M) is currency (coins and banknotes) AND verifiable deposits.

When I asked for a loan for my boat, the bank called me and said that they had deposited the loan into my checking account. This new deposit is NEW MONEY created by the bank. They just turned on their computer, logged into my account and changed the amount I had. The Federal Reserve has a tool you can use to control how much money banks make. Banks use it as a guide to the interest rate to charge each other for overnight loans of excess reserves. You can view the transcript of “How banks create money: macro topic 4.4” here (opens in new window).

From this point of view, deposits are usually “created” by household savings decisions, and banks then “lend” those existing deposits to borrowers, for example, to companies looking to finance investments or to people who want to buy houses. That means that the Fed is responsible for policies that create or destroy billions of dollars every day. But the big picture is that a bank must have enough money in reserves to meet its obligations; the rest the bank lends. Instead of keeping the amount of base money fixed, central banks have recently pursued an interest rate target to control the issuance of credit by banks indirectly, so the ceiling implied in the money multiplier does not impose a limit on the creation of money in practice. In addition, the creation of real money takes place after banks lend these new balances to the broader economy. In fact, central banks have an incentive to ensure that bank deposits are safe because, if people are worried about losing their bank deposits, they can start holding more cash, rather than depositing it in banks, and the amount of loans in an economy will decrease. Through a new loan) that leaves the bank below the required reserves, it can affect the return you can expect from the loan, due to the additional cost that the bank will commit to repay within the limits of the ratio, but this does not hinder or prevent the bank's ability to grant the loan in the first place place. In short, money exists as bank deposits (commercial bank notes) and is created through simple accounting every time a bank makes a loan.

Goldsmiths realized that they could lend gold by issuing more receipts to borrowers, who agreed to return the gold plus interest. If a person takes money and deposits it into his current account, his bank maintains the necessary reserves and then lends the rest, which stimulates the process of expanding the loan. First National must withhold 10% of additional deposits as required reserves, but is free to lend the rest. In addition, the process by which banks lend in financial capital markets is closely linked to the creation of money. Halving the reserve ratio will more than double the deposit creation potential of the system. When an economy is in recession, banks are likely to have a higher share of reserves because they fear that loans will be less likely to be repaid when the economy is slow. Banks have long been known as powerful financial institutions capable of creating wealth through lending activities.

By understanding how banks create money through loans and other financial instruments such as bonds and stocks, we can better understand how our economy works and how we can use this knowledge to our advantage.

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