Home » How Banks Create Money

How Banks Create Money

How Banks Create Money

We always hear that banks create money and come to mind a banker with a magic wand and a cap. 

What is not so far removed from reality, moreover, is not only how banks create money, they also perform something similar to what Jesus Christ did with bread and fish, that is, a few do many.

The money that exists today in our societies can be divided into two types:

  1. on one side are cash (physical money composed of bills and coins),
  2. Bank money (the digital annotations like the ones we see in our account of the bank).

Cash money (coins and banknotes) can only be created by the official institution responsible for it, the central bank. Bank money, on the other hand, can be created by the same institution that manufactures banknotes and coins, but also – and above all – by private banks. Thanks to their privileged condition of creating money through the issuance of their debt in the form of deposits, when they lend money to an individual they start a money-creating circle, accelerated by the multiplier effect of money.

You may like to read:

How do you create it?

In order for banks to obtain liquidity, the country’s central bank lends them money. And what is the central bank to lend that money? Basically in the commercial bank’s long-term investments.

For example, if a bank lends 200,000 dollars to a mortgage (which is an investment of the bank), the central bank lends that bank approximately 200,000 dollars, creating that money (“printed” electronically). And in addition, the central bank will refinance the bank in the short term as many times as necessary until that mortgage is paid by the mortgaged.

Once the money is in the hands of the citizens, the banks can also multiply it. Let’s see a simple example of how banks multiply money, illustrating how in an imaginary economy, banks receive $ 1,000 and make them more than $ 90,000:

  1. Mr.Skye charges his payroll and deposits $ 1,000 in Bank A.
  2. Bank A is obliged by law to keep a percentage of that deposit in the bank’s liquid reserves, once deposited it may lend the rest of the money.

The percentage of which I speak is called the coefficient of cash.

For example, in the dollar area, the percentage is between 0 and 1%. In the example, we will use the 1%. The lower this percentage, the greater the money multiplier.

Then in Bank A, he keeps 1% of that deposit in his reserves, that is, he saves 10 $ and lends to a second person (Mr.Ignatio) the remaining $ 990.

  1. Mr. Ignatio buys a third person (Mr. Micheal) a motorcycle for 900 $, leaving him with 90 $ for his affairs.
  2. Mr.John saves those 900 $ in bank A.
  3. Bank A stores the 9 $ that it has to deposit in reserves by law and lends Stave 891 $.
  4. Mr.Stave decides to leave those 891 $ in bank B.

We are going to see how much money there is now in this economy, not counting the money that is in the reserves of the banks.

  • Mr.Skye has $ 1,000 in bank A.
  • Mr.Ignatio has 90 $ in the drawer of his house.
  • Mr.John has $ 900 in bank B.
  • Mr. Stave has $ 891 in Bank C.

At this moment there is a total of $ 2,881 in the economy. The banks have created 1,881 dollars of the 1,000 euros that Mr.Skye has entered.

If we continue to develop the example and bank C will lend Mr.Stave’s money and in turn that person deposits it in another bank and so on, assuming that each person withdraws the money from the bank and directly re-enters another bank, as they have done Mr. John and Mr.Stave, each credit granted would have the potential to give another small credit (initial credit less 1%), in a decreasing infinite series and of Mr. Stave’s 891 $ banks would create 88,209 dollars more (891 / 0.01 – 891 ).

Money created:  1.881 + 88.209 = 90.090 $

Of the 1,000 dollars that Mr.Skye entered, the banks have created another 90,090 $ that are distributed among many people.

The creation of money by the banks is due to the banks that do not lend according to the money that they have, if not of that they will have. In relation to the example, all the money has been created from the 990 dollars that bank A has lent to Mr.Ignatio and that this one has paid to Mr.John. Being the motorcycle of Mr.Ignatio, the only real asset that supports this creation of money.

Thus we can see how the banks multiply the money according to the debt.  This works as long as Mr.Ignatio pays his debt, otherwise, the process would stop. This is the unpredictable part of the debt-based money creation system.

About the author

Salman Qureshi

Salman Qureshi is an Accountant by profession & he loves to write on Commerce & Management Sciences Subject to assist Students. Hope you guys will like his effort.

Add Comment

Click here to post a comment