14.4 How Banks Create Money

The Role of Banks in Money Creation

Money Multiplier in Fractional Reserve

In a fractional reserve system, banks are only required to keep a fraction of their deposits on hand as reserves. The rest gets lent out. This simple rule is what allows banks to create money.

Here's how it works: the central bank sets a reserve requirement, the percentage of each deposit a bank must hold back. If the reserve requirement is 10%, a bank receiving a $\$1{,}000$ deposit must keep $\$100$ in reserve but can lend out the remaining $\$900$.

That $\$900$ loan doesn't just disappear. The borrower spends it, and it ends up deposited in another bank. That second bank keeps 10% ($\$90$) and lends out $\$810$. The process repeats, with each round creating a smaller new deposit, until the system has created the maximum amount of new money.

The money multiplier tells you that maximum:

$\text{Money Multiplier} = \frac{1}{r}$

where $r$ is the reserve requirement expressed as a decimal. With a 10% reserve requirement:

$\frac{1}{0.10} = 10$

So an initial deposit of $\$1{,}000$ can support up to $\$1{,}000 \times 10 = \$10{,}000$ in total deposits across the entire banking system. The key takeaway: banks expand the money supply well beyond the original monetary base through this chain of lending and redepositing.

Keep in mind this is the theoretical maximum. In practice, the actual multiplier is smaller because banks sometimes hold excess reserves (more than required), and not every dollar lent out gets redeposited into the banking system.

T-Account Balance Sheets for Banks

A T-account is a simplified balance sheet that shows a bank's assets on the left and liabilities plus equity on the right. The two sides must always be equal. T-accounts are the best way to trace how money creation actually shows up on a bank's books.

Walk through a single round of the process:

1. A customer deposits $\$1{,}000$. The bank records $+\$1{,}000$ in cash (asset) and $+\$1{,}000$ in deposits owed to the customer (liability).

1. With a 10% reserve requirement, the bank must hold $\$100$ as required reserves and can lend out $\$900$. When it makes the loan, the bank creates a new $\$900$ deposit in the borrower's account.

Notice that both sides still balance. The loan is an asset to the bank (the borrower owes them money), and the new deposit is a liability (the bank owes the borrower access to those funds).

1. The borrower spends the $\$900$, which flows to another bank. That bank now goes through the same process: hold 10%, lend the rest.

By tracking T-accounts across multiple banks and rounds, you can see the money multiplier in action. Each round adds new deposits (liabilities) and new loans (assets) to the banking system.

Banks must also maintain enough liquidity to handle customer withdrawals. If too many depositors try to withdraw at once and the bank can't meet the demand, the result is a bank run.

Economic Impacts of Bank Money Creation

Bank money creation has real consequences for the broader economy, both positive and negative.

Benefits:

• Increased lending funds business investment and consumer spending, which stimulates economic growth
• Greater access to credit helps businesses expand operations and create jobs
• More money circulating through the economy drives demand for goods and services

Risks:

• Excessive lending can inflate asset bubbles (think housing prices rising far above their actual value), which destabilize the financial system when they burst
• When borrowers default on loans, banks absorb losses. Enough defaults can cause bank failures.
• Bank failures contract the money supply because the lending chain works in reverse. This can deepen recessions.
• If the money supply grows faster than the economy's production of goods and services, the result is inflation

Central banks and regulators use several tools to manage these risks:

• Reserve requirements control how much banks must hold back from lending
• Capital requirements force banks to maintain a cushion of their own funds to absorb losses
• Interest rate adjustments make borrowing more or less attractive, influencing how much new money the banking system creates

Financial Intermediation and Banking System Stability

Banks serve as financial intermediaries, channeling funds from savers (who deposit money) to borrowers (who need capital). This intermediation process is what makes efficient allocation of capital possible. Without it, savers and borrowers would have to find each other directly, which would be slow and risky.

The tension at the heart of banking is that the same lending activity that creates money and drives growth also introduces risk. Regulatory measures like reserve requirements, capital requirements, and deposit insurance exist to keep that risk in check so banks can withstand economic shocks without collapsing.