13 November 2010

Money Creation – Basic Principle

Now let’s take a look to the basic principle of money creation in fractional reserve banking, since understanding this is one of the most crucial things for understanding the processes in financial world. What does mean “Money is debt”, and how can banks create money out of thin air as it’s often said ironically? The following simple example should explain this.

Suppose there is only one commercial bank in the economy. Suppose further that people have all together 1,000 units of money and that they have deposited it into the bank. Bankers think that well, it’s unlikely that people would come and ask for all the money and all at the same time. So they decide to always keep 10% of deposits for liquidity reasons (let’s call this 10% as “reserve ratio”), and lend out the other 900 units. This is the business and function of banks: take deposits from those who have surplus of money, and grant loans to those who have deficit of it, pay low interests to depositors and ask higher interests from borrowers.

So the bank’s balance sheet to begin with, when omitting all the items that are not essential for the current example, looks as follows:


Now the bank lends the available 900.00 to people who want to buy homes, to entrepreneurs who have to invest it into equipment etc. Borrowers do not need to take cash out of the bank; instead, they can make electronic payments for their houses, machines or whatever. Thus the bank writes the borrowed 900.00 to deposit accounts and it remains to be deposited into the bank. On the left side of the balance sheet, the bank now has an asset called “Loans to the public” in the amount of 900.00. As no real money has moved out of the bank, the bank still has 1000.00 units of it in the safe or wherever cash is kept. It only has to increase liquidity reserves as now people have deposits in the amount of 1,900. 10% (the decided reserve ratio) of 1,900 is 190; thus the bank now keeps 190.00 as liquidity reserves and the rest (1000.00 in cash minus 190.00 in reserves) is still available for lending. At this stage, the bank’s balance sheet looks as follows:


What do we see? The total amount of money in the economy has increased from 1,000 units to 1,900 units, as households and enterprises now have 1,900 units of money in deposits. So simple was that.

The bank still has 810.00 available for lending. So, new borrowers can come and get loans. Again, the logic is the same: on the right side of the balance sheet deposits will increase in the same amount (810.00) as will increase loans to the public on the left side of the balance sheet. After this next “round”, loans to the public will amount to 1,710.00 (900+810), and deposits to 2,710.00 (1900+810). The bank will have to keep in liquidity reserves 271.00 (10% of 2,710, as was the decided reserve ratio), and the available cash for new lending is now 729.00 (total cash of 1,000 units minus liquidity reserves of 271 units). After this “money creation stage”, the total amount of money in economy is 2,710 units.

How long the described money creation process can continue? Until there are so many deposits that the bank has to keep all cash in liquidity reserves. Mathematically, the amount of money in economy can grow up to the amount which is equal to the original amount (that is 1,000 units) divided by the reserve ratio (which is 10% in the current example). In our example, this would be 1,000/10%=10,000 units. The respective maximum amount of loans would be 9,000 units and the reserves would amount to 1,000 units.

Here is a graphical illustration of the whole process:


As you probably have noted, the reserve ratio is the key of how much lending can be done and thus, how much money can be created. Minimum requirement with this regard can be (and normally should be) set by regulators. However, even if the regulators will not do it, the banks by themselves need to be prudent and keep some reserves.

Based on this simple example you can continue “playing money game” on paper or in Excel, and see what deleveraging means if households, enterprises and governments would start paying back all their loans. Money is debt. No debt, no money.

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