Commercial Banks Can Create Money by Expanding Money Supply

Commercial banks have the power to create money by expanding the money supply. They do this by making loans to customers, which increases the amount of money circulating in the economy.

By lending money to customers, banks create new deposits in those customers' accounts, which in turn increases the money supply. For example, if a bank lends $100 to a customer, the customer's account balance increases by $100, and the bank's assets increase by $100.

This process is often referred to as "fractional reserve banking", where banks are only required to hold a fraction of their deposits in reserve, rather than all of them. This allows banks to lend out a significant portion of their deposits, creating new money in the process.

Money creation is a fundamental concept in banking, and it's based on the idea that commercial banks can create new money by making loans to their customers.

Commercial banks create new money by lending it to their customers, which is made possible by the fact that they hold only a fraction of their customers' deposits in reserve.

For example, when a customer deposits $100 into a bank, the bank might keep $10 in reserve and lend out the remaining $90 to another customer.

The money that commercial banks create through lending is often referred to as "credit money", which is a type of money that is created through the banking system rather than being printed by a central authority.

The amount of money that commercial banks can create is limited by the amount of deposits they receive, which is known as the money multiplier effect.

Banks can create money by lending out deposits to customers, but it's not just a simple matter of printing more cash. In fact, the central bank only prints new currency when it hires a professor for consulting work, as seen in Period 1 of the example.

This initial deposit of $100 is then deposited into a retail bank, which operates with a 10% reserve ratio. This means that the bank keeps $10 of the deposit in reserve and lends out the remaining $90 to a customer. The money supply remains at $100, but now there are two people with money in the economy.

Banks can lend out a significant portion of deposits because they don't need to keep all of them in reserve. In fact, the reserve ratio can be as low as 0.1, as seen in the consolidated balance sheet for U.S. commercial banks in January 2012. This means that banks can lend out 90% of deposits, creating new money in the process.

The deposit multiplier is a key concept in understanding how banks create money. It's the ratio of the maximum possible change in checkable deposits to the change in reserves. In our example, the deposit multiplier was 10, which means that a $100 deposit can create $1,000 in new money. This is because the bank can lend out the $90 deposit to multiple customers, each of whom can then deposit the money into their own accounts.

Here's a breakdown of the deposit multiplier formula:

Equation 9.1: md = ∆D / ∆R

Where md is the deposit multiplier, ∆D is the change in checkable deposits, and ∆R is the change in reserves.

The deposit multiplier is also related to the required reserve ratio, which is the fraction of deposits that banks must keep in reserve. A higher required reserve ratio means a lower deposit multiplier, as seen in the example where a required reserve ratio of 0.2 produces a deposit multiplier of 5.

Overall, the process of money creation is complex and involves multiple factors, including the reserve ratio, the deposit multiplier, and the behavior of customers. But at its core, banks create money by lending out deposits to customers, which can then be deposited into other accounts and spent.

The Federal Reserve plays a crucial role in regulating the money supply in the United States. It determines the reserve ratio, which is the fraction of deposits that banks must keep in reserve.

Banks lend out the rest of the deposits to earn a profit on the spread between the interest rate they pay depositors and the one they charge borrowers. This system is known as fractional reserve banking, where banks hold reserves whose value is less than the sum of claims outstanding on those reserves.

The Federal Reserve Statistical Release H.8 shows the financial situation of all commercial banks in the United States. In January 2012, the total assets of commercial banks were $12,497.2 billion, with total liabilities of $11,155.4 billion.

The difference between total assets and total liabilities is net worth, which was $1,341.8 billion for commercial banks in January 2012. This net worth is a key indicator of a bank's financial health.

Here's a breakdown of the assets and liabilities of commercial banks in January 2012:

This balance sheet provides a snapshot of the financial situation of commercial banks in the United States in January 2012.

The U.S. money supply is made up of currency, like dollar bills and coins, and deposits held by the public at commercial banks and other institutions.

On June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion.

This narrow measure of money is known as M1, which reflects money's function as a medium of exchange.

The money supply can also be measured more broadly, including some types of savings deposits, which totaled $6,275 billion.

This broader measure is known as M2, which reflects money's function as a store of value.

Fiat money, which makes up the U.S. money supply today, is money that national monetary authorities have the power to issue without legal constraints.

The U.S. money supply is made up of currency, dollar bills and coins issued by the Federal Reserve System and the U.S. Treasury, and various kinds of deposits held by the public at commercial banks and other depository institutions.

As of June 30, 2004, the money supply, measured as the sum of currency and checking account deposits, totaled $1,333 billion.

The money supply has different measures, including M1, M2, and M3, which correspond to three definitions of money used by the Federal Reserve.

The definition of money has changed over time, with physical commodities like silver or gold serving as money for centuries.

In 1971, President Richard M. Nixon discontinued converting U.S. dollars into gold at $35 per ounce, making the U.S. money supply into fiat money, which national monetary authorities can issue without legal constraints.

Including some types of savings deposits, the money supply totaled $6,275 billion, and an even broader measure totaled $9,275 billion.

M0, the monetary base, is the narrowest measure of the money supply, including only physical currency in circulation and reserves held by commercial banks at the central bank.

M1, on the other hand, is a broader measure that includes everything in M0, plus demand deposits in commercial banks, which are funds that depositors can withdraw on demand using checks or debit cards.

The key difference between M0 and M1 lies in what types of assets they include, with M0 being more limited in scope.

In an economy built on fractional reserve banking, only a portion of a bank's deposits are kept in reserve, and the rest are loaned out or invested, which can work as long as depositors don't demand too much of their cash at once.

Money and credit are often used to gauge the overall health of an economy, but which one provides more useful information? According to the data, credit growth is a marginally more useful statistical indicator of economic growth than money growth.

The study found that adding current and past lags of credit growth to a simple model of nominal GDP growth improved the model's explanatory power significantly, with the sum of coefficients on the credit terms being statistically significant at the 5% level.

However, the contribution of the credit variable to the model is very modest, explaining only about 22% of the variation in the current growth of nominal GDP.

Here's a comparison of the models:

As you can see, the models that include credit growth perform better than the ones that only include money growth. But it's essential to remember that even the best models can only explain a small portion of the variation in economic growth.

Adding both money and credit terms to the model at the same time only makes credit growth statistically significant, suggesting that credit growth is a more reliable indicator of economic growth.

Commercial banks can create money by issuing loans, which is a key way they contribute to the money supply. This process is called credit creation.

The money supply in an economy is influenced by the amount of credit created by commercial banks. As banks issue more loans, the money supply increases, which can lead to inflation.

Commercial banks can create new money by lending to businesses and individuals, and the amount of new money created is typically several times the amount of deposits used to fund the loans. For example, if a bank uses $100 in deposits to fund a loan, it can create $900 in new money.

The money created by commercial banks is not physical cash, but rather digital entries in their customers' accounts. This digital money can be used to make purchases, pay bills, and transfer funds.

The ability of commercial banks to create money has significant implications for monetary policy and the overall economy. Central banks can influence the money supply by adjusting interest rates, which affects the amount of credit created by commercial banks.

Commercial banks can create money by lending out excess reserves, which are funds deposited by customers but not immediately withdrawn. This process is called fractional reserve banking.

The reserve ratio, which determines how much of a deposit a bank must keep in reserve, is a crucial factor in this process. In the example, Bank 1 operates with a 10% reserve ratio, keeping $10 of the $100 deposit in reserve and lending out the remaining $90.

As we've seen, this can lead to a significant increase in the money supply. In Period 3, the money supply increased from $100 to $190, and by Period 5, it had grown to $271, all without the central bank printing any new currency.

In the past few weeks, I've been noticing how banks create money through a process called fractional reserve banking. A central bank prints $100 and gives it to a professor as payment for his work, instantly increasing the money supply to $100.

Banks operate with a reserve ratio, where they keep a portion of deposits in reserve and can lend out the rest. Bank 1, for example, kept $10 of the professor's $100 deposit in reserve and loaned out the remaining $90 to Mrs. Franco.

The money supply has been growing rapidly as banks continue to lend out excess reserves. In period 3, the money supply increased to $190, and by period 5, it had reached $271. This is all happening without the central bank printing any new physical currency.

It's fascinating to see how a single deposit can trigger a chain reaction of lending and spending, ultimately leading to a significant increase in the money supply.

Banks are financial intermediaries that accept deposits, make loans, and provide checking accounts for their customers.

They operate on a fractional reserve system, where they must keep a fraction of the funds deposited by their customers in reserve, known as the reserve ratio. This ratio is typically 10% or less, as seen in Example 1.

Banks lend out the rest of the deposits to earn a profit on the spread between the interest rate they pay depositors and the one they charge borrowers. This is a key aspect of fractional reserve banking, as mentioned in Example 2.

A bank's financial picture can be depicted using a simplified balance sheet, which shows assets, liabilities, and net worth. Assets include loans, securities, and other assets, while liabilities include checkable deposits, borrowings, and other liabilities.

The main way banks earn profits is through issuing loans, as shown in Table 9.1 from Example 4. Most bank assets are in the form of loans, which are then used to create new money within the banking system.

Banks are heavily regulated and bank deposits are insured, as mentioned in Example 5. This provides a level of security for depositors and helps to maintain the stability of the financial system.

Here's a key point to remember: money is created within the banking system when banks issue loans, and it is destroyed when the loans are repaid.

Commercial banks can create money by issuing loans, which is a fundamental concept in the banking system. This process is known as the creation of new money.

Banks are financial intermediaries that accept deposits, make loans, and provide checking accounts for their customers. They play a crucial role in the economy, and their operations are heavily regulated.

The creation of new money occurs when a bank issues a loan, which increases the money supply. Conversely, when a loan is repaid, the money is destroyed. This process is a key aspect of the banking system.

The deposit multiplier is a concept that helps us understand how the money supply is affected by changes in reserves. It's calculated as the reciprocal of the required reserve ratio.

Here's a key concept to keep in mind: an increase (decrease) in reserves in the banking system can increase (decrease) the money supply. The maximum amount of the increase (decrease) is equal to the deposit multiplier times the change in reserves.

Bank deposits are insured, which provides a layer of protection for customers in case a bank fails. This is an important aspect of the banking system, and it helps to maintain confidence in the financial system.

Regulations, such as the Dodd-Frank Act, are put in place to ensure that banks operate in a safe and sound manner. These regulations are designed to prevent the kind of financial crisis that occurred in 2008.