Do Banks Create Money When They Make Loans

Chapter 27. Money and Banking

27.4 How Banks Create Money

Learning Objectives

By the cease of this section, yous will be able to:

• Utilize the money multiplier formulate to determine how banks create coin
• Analyze and create T-account residue sheets
• Evaluate the risks and benefits of money and banks

Banks and money are intertwined. Information technology is not just that nearly money is in the grade of bank accounts. The banking system can literally create money through the process of making loans. Let'due south see how.

Money Cosmos by a Unmarried Banking concern

Start with a hypothetical depository financial institution called Singleton Bank. The bank has $ten million in deposits. The T-business relationship balance sheet for Singleton Banking concern, when it holds all of the deposits in its vaults, is shown in Figure one. At this stage, Singleton Depository financial institution is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn whatsoever interest income from these loans and cannot pay its depositors an involvement charge per unit either.

Figure 1. Singleton Bank's Balance Sheet: Receives $10 one thousand thousand in Deposits.

Singleton Bank is required by the Federal Reserve to go on $1 1000000 on reserve (x% of total deposits). It will loan out the remaining $9 million. By loaning out the $ix million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will continue it simple and not put interest income on the balance canvas). Instead of becoming only a storage identify for deposits, Singleton Bank tin can become a financial intermediary between savers and borrowers.

This change in business plan alters Singleton Bank'south balance sheet, every bit shown in Figure 2. Singleton's avails have changed; it now has $1 million in reserves and a loan to Hank's Auto Supply of $9 million. The bank still has $ten one thousand thousand in deposits.

Effigy ii. Singleton Bank's Balance Sheet: 10% Reserves, One Circular of Loans.

Singleton Banking company lends $nine million to Hank's Auto Supply. The banking company records this loan by making an entry on the balance sheet to indicate that a loan has been fabricated. This loan is an asset, because information technology volition generate interest income for the bank. Of form, the loan officer is not going to let Hank walk out of the bank with $ix one thousand thousand in cash. The bank issues Hank's Auto Supply a cashier's check for the $9 meg. Hank deposits the loan in his regular checking business relationship with First National. The deposits at Start National ascension by $9 1000000 and its reserves also rise past $nine million, as Figure 3 shows. Beginning National must hold 10% of additional deposits equally required reserves just is complimentary to loan out the restFirst National Balance Canvas

Figure 3. Starting time National Balance Sheet. .

Making loans that are deposited into a need deposit account increases the M1 money supply. Think the definition of M1 includes checkable (need) deposits, which can be easily used as a medium of exchange to buy goods and services. Find that the money supply is at present $nineteen million: $x 1000000 in deposits in Singleton banking company and $9 1000000 in deposits at Start National. Obviously these deposits will be drawn down equally Hank's Motorcar Supply writes checks to pay its bills. But the bigger moving picture is that a bank must hold plenty money in reserves to run across its liabilities; the rest the bank loans out. In this example and so far, banking concern lending has expanded the money supply past $9 meg.

At present, Starting time National must hold simply x% as required reserves ($900,000) but tin lend out the other 90% ($viii.1 one thousand thousand) in a loan to Jack's Chevy Dealership as shown in Figure 4.

Effigy 4 Get-go National Rest Sail.

If Jack's deposits the loan in its checking account at 2nd National, the money supply just increased past an additional $8.1 one thousand thousand, equally Figure 5 shows.

Figure five. Second National Depository financial institution's Residue Sheet.

How is this coin creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end upwards deposited in other banks, which increases deposits and, in essence, the money supply.

Watch this video to learn more than about how banks create coin.

The Money Multiplier and a Multi-Bank System

In a system with multiple banks, the initial excess reserve amount that Singleton Depository financial institution decided to lend to Hank'southward Car Supply was deposited into Frist National Bank, which is complimentary to loan out $eight.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-banking concern organization, the amount of money that the organization can create is plant past using the coin multiplier. The money multiplier tells us past how many times a loan will be "multiplied" as it is spent in the economic system and then re-deposited in other banks.

Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking organisation. The money multiplier formula is:

[latex]\frac{1}{Reserve\;Requirement}[/latex]

The money multiplier is so multiplied past the change in backlog reserves to decide the total amount of M1 money supply created in the banking system. See the Work information technology Out characteristic to walk through the multiplier calculation.

Using the Money Multiplier Formula

Using the money multiplier for the example in this text:

Footstep one. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.ten), the coin multiplier is 1 divided past .ten, which is equal to ten.

Pace two. We have identified that the excess reserves are $9 meg, then, using the formula nosotros can determine the full alter in the M1 money supply:

[latex]\brainstorm{array}{r @{{}={}} l}Total\;Change\;in\;the\;M1\;Money\;Supply & \frac{1}{Reserve\;Requirement}\;\times\;Excess\;Requirement \\[1em] & \frac{i}{0.10}\;\times\;\$9\;meg \\[1em] & 10\;\times\;\$ix\;million \\[1em] & \$90\;million \cease{array}[/latex]

Step 3. Thus, we tin say that, in this example, the total quantity of money generated in this economy afterwards all rounds of lending are completed will be $90 million.

Cautions about the Money Multiplier

The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Banking company. Additionally, a banking concern can also choose to concur actress reserves. Banks may decide to vary how much they concord in reserves for two reasons: macroeconomic atmospheric condition and regime rules. When an economy is in recession, banks are probable to concur a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy motility to touch on the quantity of coin in an economy, as Monetary Policy and Banking concern Regulation volition talk over.

The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a upshot of bank loans that are re-deposited and loaned out, again, and again.

Finally, the money multiplier depends on people re-depositing the coin that they receive in the banking organisation. If people instead store their cash in safe-eolith boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the course of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their depository financial institution deposits, they may commencement belongings more money in cash, instead of depositing it in banks, and the quantity of loans in an economic system will decline. Low-income countries take what economists sometimes refer to as "mattress savings," or money that people are hiding in their homes because they practise non trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will refuse.

Watch a video of Jem Bendell discussing "The Money Myth."

Money and Banks—Benefits and Dangers

Money and banks are marvelous social inventions that assist a mod economic system to function. Compared with the alternative of barter, coin makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more than effective in facilitating exchanges in appurtenances and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the cosmos of money.

Just the extraordinary economical gains that are possible through money and cyberbanking also suggest some possible corresponding dangers. If banks are not working well, it sets off a pass up in convenience and safety of transactions throughout the economy. If the banks are under financial stress, considering of a widespread decline in the value of their assets, loans may become far less bachelor, which tin can bargain a crushing accident to sectors of the economy that depend on borrowed money like business investment, home construction, and machine manufacturing. The Not bad Recession of 2008–2009 illustrated this pattern.

The Many Disguises of Money: From Cowries to Bit Coins

The global economic system has come a long way since it started using cowrie shells as currency. We have moved abroad from commodity and commodity-backed paper coin to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, also. Every twenty-four hours, nosotros witness the increased use of debit and credit cards.

The latest creation and perchance ane of the purest forms of fiat money is the Bitcoin. Bitcoins are a digital currency that allows users to purchase goods and services online. Products and services such as videos and books may be purchased using Bitcoins. It is not backed by any article nor has it been decreed by whatever government as legal tender, yet it used equally a medium of substitution and its value (online at least) can be stored. It is as well unregulated by any cardinal bank, but is created online through people solving very complicated mathematics bug and getting paid later on. Bitcoin.org is an information source if you are curious. Bitcoins are a relatively new blazon of money. At present, because information technology is non sanctioned as a legal currency past any land nor regulated by any key banking concern, it lends itself for use in illegal trading activities as well every bit legal ones. Every bit applied science increases and the need to reduce transactions costs associated with using traditional forms of coin increases, Bitcoins or some sort of digital currency may replace our dollar nib, just as the cowrie beat out was replaced.

Key Concepts and Summary

The coin multiplier is defined as the quantity of money that the banking organization tin can generate from each $ane of bank reserves. The formula for calculating the multiplier is 1/reserve ratio, where the reserve ratio is the fraction of deposits that the bank wishes to hold equally reserves. The quantity of money in an economy and the quantity of credit for loans are inextricably intertwined. Much of the money in an economy is created by the network of banks making loans, people making deposits, and banks making more loans.

Given the macroeconomic dangers of a malfunctioning cyberbanking system, Monetary Policy and Bank Regulation will hash out authorities policies for controlling the coin supply and for keeping the cyberbanking arrangement safe.

Cocky-Check Questions

Imagine that you lot are in the position of buying loans in the secondary market (that is, buying the correct to collect the payments on loans made past banks) for a depository financial institution or other financial services company. Explain why you lot would be willing to pay more or less for a given loan if:

1. The borrower has been tardily on a number of loan payments
2. Involvement rates in the economy equally a whole have risen since the loan was made
3. The borrower is a business firm that has just alleged a high level of profits
4. Interest rates in the economic system as a whole take fallen since the loan was made

Review Questions

1. How do banks create money?
2. What is the formula for the money multiplier?

Critical Thinking Questions

1. Should banks accept to hold 100% of their deposits? Why or why not?
2. Explain what will happen to the coin multiplier process if there is an increase in the reserve requirement?
3. What do you recall the Federal Reserve Bank did to the reserve requirement during the Great Recession of 2008–2009?

Problems

Humongous Banking company is the only banking concern in the economy. The people in this economy have $20 million in coin, and they deposit all their coin in Humongous Bank.

1. Humongous Depository financial institution decides on a policy of property 100% reserves. Draw a T-account for the bank.
2. Humongous Banking company is required to concur 5% of its existing $twenty one thousand thousand as reserves, and to loan out the rest. Draw a T-account for the bank afterward this first round of loans has been made.
3. Presume that Humongous depository financial institution is office of a multibank organization. How much will money supply increment with that original loan of $19 million?

References

Bitcoin. 2013. www.bitcoin.org.

National Public Radio. Lawmakers and Regulators Take Closer Look at Bitcoin. November xix, 2013. http://thedianerehmshow.org/shows/2013-eleven-19/lawmakers-and-regulators-take-closer-look-bitcoin.

Glossary

money multiplier formula

full money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a alter in the original quantity of money

Solutions

Answers to Self-Check Questions

1. A borrower who has been belatedly on a number of loan payments looks mayhap less likely to repay the loan, or to repay it on time, and and so you would want to pay less for that loan.
2. If interest rates generally accept risen, and so this loan made at a time of relatively lower involvement rates looks less attractive, and you would pay less for it.
3. If the borrower is a business firm with a tape of loftier profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan.
4. If interest rates in the economy have fallen, then the loan is worth more.

Source: https://opentextbc.ca/principlesofeconomics/chapter/27-4-how-banks-create-money/

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