Do Banks Create New Money out of Thin Air?

**Re-posted after the events of the credit crunch and 700 bailout packages, enjoy the read and learn how the banks got themselves in this mess.**

Here’s the story. Banks keep on lending money, but where do they get it from? Do they borrow from bigger banks who borrow from bigger banks who borrow from the central bank who then prints the money? Is it as simple as just printing more money?

Turns out money creation sometimes appears out of thin air. All banks lend based on a reserve ratio of their deposit: they must keep a certain % of each deposit at the bank but can lend out the rest. Of course, the whole system is dependent on a) the bank being responsible with lending, b) everyone not defaulting on their loans. If these two things happen eventually the system faces massive losses which is what we’re seeing in the current market.

Let’s observe a fictitious situation to help us understand how the bank gets or ‘creates’ their money. Note: when the term ‘bank’ is used in this article it will refer to your bank and not the central bank (Federal Reserve for the US.)


Let’s build a scenario where there is on bank called National Bank (operating as a monopoly). Suppose a person in another country sends $1000 and they deposit it into the bank. This becomes a NEW deposit for the bank (a PRIMARY deposit).

BANK:

At this point there is no change in the Ms (money supply), only the composition of it. M1 outside bank to M1 in demand deposits.

The bank will now: A) Keep a little in reserve to meet cash demands, B) Lend the rest out to worthy borrowers.

Let’s assume the Bank has a desired target reserve ratio of .15 (15%) to cover customer cash demands (when you go to the bank and withdraw cash). For $1000 they will keep $150 and lend out $850.

When someone borrows the $850, eventually it will reach the bank again (unless they put it underneath their mattress). Remember we are in a one bank scenario (monopoly).
Bank Now Has:

The total Ms is now $1850.

The Bank holds 15% of 1850 in reserve & lends the rest out. This process repeats itself indefinitely until they can no longer lend out money. This whole concept is called: DEPOSIT CREATION MULTIPLIER.

A quick way to determine the theoretical maximum a bank can lend out is this formula:

New Deposit / Target Reserve Ratio =

ex. $1000 / .15 = $6666.67 in new deposits (Ms increases by this much as well).

The theoretical maximum of course depends on whether the target reserve ratio is correct. Some things that affect the max include: a) number of worthwhile borrowers, b) no currency drain, c) no precautionary balances, d) no clearing drain.

Here are some additional items that may affect how much money the bank can create.

Deposit Creation Multiplier (Modifications)

Base case –> $1000 / .15 = $6,666.67

1) Suppose a 5% currency drain = money supply will only expand to $1000 / .15 + 0.05 = $1000/ .20 = $5000

– Final position of bank –
Assets Liabilities
Cash $750 Deposits $5000
Loans $4250

2) Suppose the banks decide to hold additional precautionary balances of 5%
Ms only expand to = $1000/ .15 + .05 + .05 = $4000

3) Suppose banks have foreign currency deposits and choose to hold additional reserves of .02 (2%)

Ms will (only expand to): $1000 / .15 + .05 + .05 + .02 = $3, 703.70

These are simplistic examples of how banks create money using the scenario of a single Bank acting as a monopoly in the banking industry. It may seem like money is created out of thin air but that’s not exactly the case because behind every loan is an asset. Huge trouble develops when the asset becomes worthless (many homes); someone needs to face all the losses.

Also, this does not highlight how the Federal Reserve creates money, they can actually print more money but, again, it’s not out of ‘thin air’, it’s based on the debt created by a debt note usually in the form of a government bond.

Related deposit creation multiplier equations:

TD = ID / crr

Where: TD=change in Total Deposits ID=Initial change in Deposit ccr=cash reserve ratio

?R / ?D = r
or
?D = 1 / r × ?R

Where r = the required reserve ratio. This formula tells us how much deposits increase by the multiple   1 / r  > 1 : Since r < 1, 1 / r > 1

1 / r = simple deposit multiplier. When the central bank supplies the system with an addition $1 in reserves, deposits increase by the multiple $(1/r) > $1.

Read another related article to money and banking located here.