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The Magic of Money Creation

Are you thinking to save money in your bank account? Do banks lend out our deposits? How do they create money? Well, banks don’t have the best reputation. Probably you have heard that banks make money out of your money. Many have the intuition of banks using public deposits to create loans and earning the pay-back amount and the interest rate. Free money…?

Most of the money in our economy is created by banks, in the form of bank deposits. They create new money whenever they make loans. Around 90% of the money in the economy today exists as bank deposits. Worldwide, money deposited in savings and checking accounts is approximately 37 trillion US dollars.

Many textbooks and the public believe that banks allocate funds from savers to borrowers. According to this view,  banks act merely as intermediaries. Thus, the saving decisions from households and firms create new deposits while banks lend out these existing deposits to borrowers.

Commercial banks indeed create money in the form of bank deposits by making new loans. But, an article published by Bank of England Quarterly Bulletin the way how a bank creates money in the modern economy is different from the popular view.

For example, if you are taking out a mortgage to buy a house, the bank, typically, credits the house-owner’s bank account with the amount the mortgage as deposits instead of giving cash.  At that moment, new money is created. This new lending affects the balance sheets of different sectors of the economy. It increases your assets and your liabilities as you have to pay the loan. In the same way, the bank’s assets increase in the form of loans, while liabilities rise in the form of deposits (see the graphics below).

Consumer’s T-account before and after lending

Bank T-account before and after lending

However, changes in the bank’s T account is different according to popular belief. This view uses reserves a the source to make loans. Then, loans rise, and reserves decrease as an indication of the ‘transfer’ from savers(depositors) to borrowers. All these changes occur in the asset side of the balance sheet.

Old view: before and after lending

Banks cannot lend out their reserves. Reserves can only be lent between banks since consumers do not have access to reserves accounts at the Central Banks. Therefore, creating money does not alter the quantity of Monetary Base at the Central Bank.

Besides, the notion that banks can only lend out pre-existing money, the savings from households and firms, is erroneous.  Bank deposits are simply a record of how much the bank itself owes its customers.  So they are a liability of the bank, not an asset that could be lent out.

Money is destroyed through the repayment of the loans. Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.

Although banks would create money through their lending behaviour infinite times, in practice, banks are constrained by some limitations. The price of loans, interest rate,  is one of them. It determines the willingness of households and firms to acquire loans, and therefore the demand for loans. Also, competitiveness and market forces limit lending as banks should maintain profitability. Every loan has risk involved, and banks consider probabilities of default. The regulation applied to the financial markets helps to mitigate the possible accumulation of risks and threats to the stability of the financial system.

It is clear that banks help an economy function efficiently. When money exchanges hands for goods or services, it boosts economic activity. Nonetheless,  weak and unreliable banking infrastructure becomes a common obstacle for developing countries. Lack of regulation, for example, position the banking system in danger as banks may be incentivised to lend without limits.


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