### Date : 2024-07-15 16:07 ### Topic : How Banks Create Money #macroeconomics #money ---- ### 9.2 How Banks Create Money #### Introduction Banks play a crucial role in the economy by facilitating the creation of money through the process of accepting deposits and issuing loans. This process significantly impacts the money supply and overall economic activity. Understanding how banks create money involves exploring concepts like fractional reserve banking, the money multiplier, and central bank policies. #### Key Concepts 1. **Fractional Reserve Banking** **Definition:** Fractional reserve banking is a system in which banks keep a fraction of their deposits as reserves (either in their vaults or at the central bank) and lend out the remainder. **Mechanism:** - **Reserves:** Banks are required to hold a certain percentage of deposits as reserves. This requirement ensures that banks have enough funds to meet withdrawal demands. - **Lending:** The remaining portion of deposits can be lent out to borrowers. When a bank issues a loan, it credits the borrower's account with a deposit, effectively creating new money. **Example:** If the reserve requirement is 10%, and a bank receives a $1,000 deposit, it must keep $100 in reserves and can lend out $900. The borrower then deposits the $900 in another bank, which can lend out 90% of it ($810), and so on. This process continues, creating more money in the economy. 2. **Money Multiplier** **Definition:** The money multiplier measures the maximum amount of commercial bank money that can be created, given a certain amount of central bank money (reserves). **Formula:**  **Explanation:** The money multiplier shows how an initial deposit can lead to a larger increase in the total money supply. For example, with a reserve ratio of 10%, the money multiplier is 10, meaning that every $1 of reserves can support $10 of total money supply through the lending process. **Example:** If a central bank injects $1,000,000 into the banking system and the reserve ratio is 10%, the total potential increase in the money supply is:  3. **Role of Central Banks** **Definition:** Central banks, such as the Federal Reserve in the U.S. or the Bank of Korea, regulate the money supply and ensure financial stability through monetary policy tools. **Monetary Policy Tools:** - **Reserve Requirements:** Central banks set reserve ratios that determine the fraction of deposits banks must hold as reserves. - **Open Market Operations:** Central banks buy or sell government securities to increase or decrease the money supply. - **Discount Rate:** The interest rate charged to commercial banks for borrowing funds from the central bank. Lowering the discount rate makes borrowing cheaper, encouraging banks to lend more. **Example:** During economic downturns, central banks may lower reserve requirements or purchase government securities to inject liquidity into the banking system, promoting lending and economic activity. #### Detailed Analysis 1. **Deposit Creation and the Banking System** When a bank receives a deposit, it records the deposit as both an asset (cash) and a liability (customer deposit). The bank then lends out a portion of this deposit while keeping a fraction as reserves. The loaned amount becomes a new deposit in another bank, which can then lend out a portion of that deposit. This cycle continues, expanding the money supply. **Steps in Deposit Creation:** 1. **Initial Deposit:** $1,000 deposited in Bank A. 2. **Reserves and Loans:** Bank A keeps $100 (10%) in reserves and lends $900 to a borrower. 3. **Secondary Deposit:** The borrower deposits $900 in Bank B. 4. **Further Lending:** Bank B keeps $90 (10%) in reserves and lends $810. 5. **Cycle Continues:** The process repeats, multiplying the initial deposit's impact on the money supply. 6. **Impact of Reserve Requirements** Reserve requirements directly influence the money multiplier and, consequently, the money supply. A lower reserve requirement means banks can lend more, increasing the money supply. Conversely, a higher reserve requirement restricts lending, reducing the money supply. **Example:** If the reserve ratio is reduced from 10% to 5%, the money multiplier increases from 10 to 20, significantly enhancing the banking system's ability to create money. 3. **Open Market Operations** Central banks use open market operations to manage the money supply by buying or selling government securities. Purchasing securities injects money into the banking system, increasing reserves and enabling more lending. Selling securities withdraws money from the system, reducing reserves and constraining lending. **Example:** To combat recession, a central bank might buy $500 million worth of government bonds from commercial banks, increasing their reserves and enabling more lending, thus stimulating economic activity. 4. **The Discount Rate and Its Effects** The discount rate influences the cost of borrowing for commercial banks. A lower discount rate reduces borrowing costs, encouraging banks to borrow more from the central bank and lend more to customers. This increased lending boosts the money supply and economic activity. **Example:** If the central bank lowers the discount rate from 2% to 1%, commercial banks find it cheaper to borrow funds, which they can then lend to businesses and consumers at lower interest rates, promoting spending and investment. ### Conclusion Understanding how banks create money is fundamental to grasping modern monetary economics. Through the fractional reserve banking system, money multipliers, and central bank policies, banks significantly influence the money supply and overall economic activity. These mechanisms illustrate the delicate balance central banks must maintain to ensure economic stability and growth. --- ### Case Study 1: How Banks Create Money in the United States #### Background The United States banking system is a prime example of how fractional reserve banking works in practice, influencing the money supply and overall economic activity. This case study examines the mechanisms through which U.S. banks create money, particularly focusing on the events following the 2008 financial crisis and the COVID-19 pandemic. #### Fractional Reserve Banking in Action **Initial Deposits and Lending:** 1. **Initial Deposit:** Suppose an individual deposits $10,000 in Bank A. 2. **Reserve Requirement:** With a reserve requirement of 10%, Bank A must keep $1,000 in reserves. 3. **Lending:** Bank A can lend out the remaining $9,000. This loan is then deposited in Bank B. 4. **Cycle Continues:** Bank B keeps $900 (10%) in reserves and lends out $8,100. This process continues across multiple banks, each time expanding the money supply. **Money Multiplier Effect:** Given a 10% reserve requirement, the money multiplier is:  This means the initial $10,000 deposit can theoretically support up to $100,000 in new money through successive rounds of lending. #### Central Bank Policies and Money Creation **Federal Reserve Actions Post-2008 Financial Crisis:** 1. **Lowering the Discount Rate:** To stimulate the economy, the Federal Reserve lowered the discount rate, making it cheaper for banks to borrow money. This encouraged banks to increase lending, thereby expanding the money supply. 2. **Quantitative Easing (QE):** The Federal Reserve purchased large amounts of government securities and mortgage-backed securities. This injected liquidity into the banking system, increasing reserves and enabling more lending. **Impact of Quantitative Easing:** - **Increasing Bank Reserves:** By purchasing securities, the Fed credited the reserves of commercial banks, increasing their capacity to lend. - **Stimulating Lending:** With more reserves and lower borrowing costs, banks were able to extend more credit to businesses and consumers, boosting economic activity. **Example:** Between 2008 and 2014, the Federal Reserve conducted three rounds of QE, purchasing over $4 trillion in assets. This significantly increased the reserves of commercial banks, leading to a substantial expansion in the money supply​ ([IMF](https://www.imf.org/en/Publications/WEO/Issues/2023/04/11/world-economic-outlook-april-2023))​. #### Case Study 2: Money Creation During the COVID-19 Pandemic **Federal Reserve's Response:** 1. **Lowering Reserve Requirements:** In March 2020, the Federal Reserve reduced reserve requirement ratios to 0% for all depository institutions. This allowed banks to use more of their deposits for lending purposes. 2. **Emergency Lending Programs:** The Fed established various lending facilities to provide liquidity to financial institutions, businesses, and municipalities. **Impact:** - **Increased Lending Capacity:** With no reserve requirements, banks had more flexibility to lend, increasing the money supply. - **Supporting Economic Activity:** The influx of liquidity helped stabilize financial markets, support businesses, and maintain consumer spending during the economic downturn. **Quantitative Easing During COVID-19:** - The Federal Reserve resumed large-scale asset purchases, buying $120 billion in Treasury securities and mortgage-backed securities per month to support the economy. **Example:** In 2020, the Federal Reserve's balance sheet expanded from about $4 trillion to over $7 trillion due to these asset purchases, injecting significant liquidity into the banking system and enabling banks to create more money through lending​ ([IMF](https://www.imf.org/en/Publications/WEO))​​ ([IMF](https://www.imf.org/en/Publications/WEO/Issues/2023/10/10/world-economic-outlook-october-2023))​. ### Conclusion The U.S. banking system's ability to create money is a powerful tool that influences economic activity. Through fractional reserve banking, the money multiplier effect, and central bank policies like lowering reserve requirements and quantitative easing, banks can significantly expand the money supply. These mechanisms played crucial roles in stabilizing the economy during the 2008 financial crisis and the COVID-19 pandemic. ### Sources - Federal Reserve - Monetary Policy - Federal Reserve Bank of St. Louis - Understanding Money Mechanics - IMF - Monetary Policy and Money Creation ### Connected Documents: -