27.4 How Banks Create Money

Banks are money-making machines, literally! They create money through lending, using a system called fractional reserve banking. This process allows banks to lend out a portion of deposits, creating new money in borrowers' accounts.

The money creation process has a multiplier effect, amplifying the initial deposit. While this system stimulates economic growth, it also carries risks like inflation and bank runs. Central banks play a crucial role in managing these risks and the overall money supply.

How Banks Create Money

Fractional Reserve Lending

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• Banks create money through lending
  • Loans create deposits in borrower's account, new money that didn't previously exist
  • Example: Bank lends $100,000 for a house, creating a$100,000 deposit in the borrower's account
• Fractional reserve system enables lending a portion of deposits
  • Banks keep a fraction (reserve requirement) of deposits on hand
  • Remaining fraction can be lent out
  • Example: 10% reserve requirement, $1,000 deposit allows$900 to be lent out
• Money multiplier amplifies initial deposit
  • Borrowed money is spent, becomes a deposit in another bank
  • Receiving bank lends a portion of new deposit, creating more money
  • Example: $1,000 initial deposit with 10$10,000 in total deposits

T-Account Balance Sheets

• T-accounts track bank assets and liabilities
  • Assets on left: Loans (money lent), Reserves (cash held)
  • Liabilities on right: Deposits (customer deposits)
• T-account must balance: Assets = Liabilities
• Example T-account:

  Assets    | Liabilities
  ----------|------------
  Loans     | Deposits
  Reserves  |
  

• Sample entries:
  • $100,000 loan: Loans +$100,000, Deposits +$100,000
  • $10,000 cash deposit: Reserves +$10,000, Deposits +$10,000

Risks and Benefits

• Benefits of bank money creation:
  • Increases money supply, stimulates economic growth
  • Enables borrowers to invest or consume
  • Banks earn interest income on loans
• Risks of bank money creation:
  • Excessive lending can cause inflation (money supply grows faster than goods and services)
  • Risky loans may lead to defaults and bank failures
  • Fractional reserves make banks vulnerable to "runs" (many simultaneous withdrawals)
• Central banks manage money supply and risks:
  • Reserve requirements: Fraction of deposits held in reserves
  • Open market operations: Buying or selling government securities influences money supply
  • Discount rate: Interest rate for banks borrowing from central bank