ECON102: Principles of Macroeconomics

Banks and money are intertwined. It is not just that most money is in the form of bank accounts. The banking system can literally create money through the process of making loans. Let's see how.

Money Creation by a Single Bank

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in Figure 14.6. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either.

Figure 14.6 Singleton Bank's Balance Sheet: Receives $10 million in Deposits

The Federal Reserve requires Singleton Bank to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 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 keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.

This change in the business plan alters Singleton Bank's balance sheet, as Figure 14.7 shows. Singleton's assets have changed. It now has $1 million in reserves and a loan to Hank's Auto Supply of $9 million. The bank still has $10 million in deposits.

Figure 14.7 Singleton Bank's Balance Sheet: 10% Reserves, One Round of Loans

Singleton Bank lends $9 million to Hank's Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan. This loan is an asset because it will generate interest income for the bank. Of course, the loan officer will not allow Hank to walk out of the bank with $9 million in cash. The bank issues Hank's Auto Supply a cashier's check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million, and its reserves also rise by $9 million, as Figure 14.8 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest.

Figure 14.8 First National Balance Sheet

Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember, the definition of M1 includes checkable (demand) deposits, which one can easily use as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton Bank and $9 million in deposits at First National. Obviously, as Hank's Auto Supply writes checks to pay its bills, the deposits will be drawn down. However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest of the bank loans out. In this example, so far, bank lending has expanded the money supply by $9 million.

Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack's Chevy Dealership, as Figure 14.9 shows.

Figure 14.9 First National Balance Sheet

If Jack deposits the loan in its checking account at Second National, the money supply will increase by an additional $8.1 million, as Figure 14.10 shows.

Figure 14.10 Second National Bank's Balance Sheet

How is this money 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 up deposited in other banks, which increases deposits and, in essence, the money supply.

The Money Multiplier and a Multi-Bank System

In a system with multiple banks, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank's Auto Supply into First National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier. This tells us how many times a loan will be "multiplied" as it is spent in the economy and then re-deposited in other banks.

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

$\dfrac{1}{\text{Reserve Requirement}}$

We then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation.

Cautions about the Money Multiplier

The money multiplier will depend on the proportion of reserves that the Federal Reserve Bank requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.

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. All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan.

Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Central banks have the incentive to assure customers that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash instead of depositing it in banks. The number of loans in an economy will decline. Low-income countries have what economists sometimes refer to as "mattress savings," or money that people are hiding in their homes because they do not 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 decline.

Money and Banks – Benefits and Dangers

Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money.

However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in the convenience and safety of transactions throughout the economy. Suppose the banks are under financial stress because of a widespread decline in the value of their assets. In that case, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money, like business investment, home construction, and car manufacturing. The 2008–2009 Great Recession illustrated this pattern.

Source: Rice University, https://openstax.org/books/principles-macroeconomics-3e/pages/14-4-how-banks-create-money
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