27.4 How Banks Create Money

How Banks Create Money

Banks don't just store your money in a vault. They actively create new money through lending, using a system called fractional reserve banking. Understanding this process explains how a single deposit can ripple through the economy and multiply into a much larger amount of money.

Fractional Reserve Lending

The core idea is straightforward: banks are only required to keep a fraction of their deposits on hand as reserves. The rest they can lend out. When they make a loan, they don't hand over someone else's cash. Instead, they credit the borrower's account with new funds. That's new money that didn't exist before.

Here's how it works step by step:

1. You deposit $1,000 in Bank A.
2. Bank A is required to hold 10% in reserves (the reserve requirement), so it keeps $100 and lends out $900.
3. The borrower spends that $900, and it ends up deposited in Bank B.
4. Bank B keeps 10% of $900 ($90) in reserves and lends out $810.
5. That $810 gets spent and deposited in Bank C, which keeps $81 and lends out $729.
6. This chain continues, with each round creating slightly less new money.

By the end of this chain, your original $1,000 deposit can generate up to $10,000 in total deposits across the banking system.

The formula behind this is the money multiplier:

$\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}$

With a 10% reserve requirement: $\frac{1}{0.10} = 10$

So the maximum new money created equals the initial deposit multiplied by the money multiplier: $\$1{,}000 \times 10 = \$10{,}000$

In practice, the actual multiplier is usually smaller than the theoretical maximum. Banks sometimes hold excess reserves (more than required), and not every dollar lent gets redeposited in a bank. But the multiplier captures the key mechanism.

T-Account Balance Sheets

A T-account is a simplified balance sheet that tracks what a bank owns and what it owes. It's the standard tool for visualizing how loans and deposits change a bank's position.

• Left side (Assets): Things the bank owns or is owed. This includes reserves (cash on hand) and loans (money borrowers owe the bank).
• Right side (Liabilities): Things the bank owes to others. Customer deposits are the main liability, since depositors can withdraw their money.

The fundamental rule: Assets must always equal Liabilities.

Here's what happens when a customer deposits $10,000 in cash:

       Assets        |    Liabilities
  -------------------|-------------------
  Reserves  +$10,000 | Deposits  +$10,000

The bank's reserves go up (it has more cash), and its liabilities go up (it owes the depositor $10,000). The account balances.

Now suppose the bank makes a $9,000 loan (keeping $1,000 as its 10% reserve). The loan creates a new deposit in the borrower's account:

       Assets        |    Liabilities
  -------------------|-------------------
  Reserves   $1,000  | Deposits  $19,000
  Loans      $9,000  |
  (previous) $9,000  |

Notice that total assets still equal total liabilities. The loan shows up as an asset (the bank is owed $9,000), and the borrower's new deposit shows up as a liability.

Risks and Benefits

Benefits of money creation through lending:

• Expands the money supply, which fuels spending, investment, and economic growth
• Gives borrowers access to funds for homes, businesses, and education
• Banks earn interest income on loans, which supports the financial system

Risks of money creation through lending:

• If banks lend too aggressively, the money supply can grow faster than the economy produces goods and services, leading to inflation
• Risky loans can lead to defaults. If enough borrowers can't repay, banks face serious losses or even failure.
• Because banks only hold a fraction of deposits in reserve, they're vulnerable to bank runs. If too many depositors try to withdraw at once, the bank simply doesn't have enough cash on hand.

How central banks manage these risks:

• Reserve requirements set the minimum fraction of deposits banks must hold, directly limiting how much they can lend
• Open market operations involve buying or selling government securities to increase or decrease the money supply
• The discount rate is the interest rate the central bank charges when commercial banks need to borrow. Raising it discourages borrowing; lowering it encourages it.

These three tools give the central bank significant control over how much money the banking system creates.