How Banks Create Money Out of Thin Air

Sat, 02 Aug 2008 15:17:37 EST

The Federal Reserve System, generally known as The Fed is the central Bank of the United States that was created by an act by U.S. Congress in December 1913. Since then all other banks lost the authority to print and issue their own currency. However, they still exercise a great deal of “power” to create money literally out of thin air with some help from The Fed, of course. Though, The Fed is the only authority to issue and print paper notes, one element of its monetary policy provides the mechanism to the rest of the banking institutions to “create” money on their own.

Commercial banks and other depository institutions “create” money through:

Fractional Reserve System--a system in which banks are required to hold reserves that is only a fraction of money deposited with them.

For example, we make a deposit of $10,000 in a bank against which we can write checks. Since we do not withdraw all of our deposit at one time, the bank can loan part of our deposit to someone else and “create” additional money. The amount of money that a bank is able to create depends upon the fraction of the deposit that The Fed requires the banks to keep as a “reserve” to ensure that they will have sufficient funds to cash checks drawn on them. We must also note that even when someone withdraws her entire deposit, others may be making a deposit at the same time. Some important terms:

Required reserve: The minimum amount of cash that a bank must have on hand or on deposit with The Fed.

Required reserve ratio: The percentage of the total deposits that The Fed requires of all types of banking institutions to hold in cash or on deposit with The Fed.

Excess reserve: The difference between the total deposits and required reserves that is at the disposal of banks that they can lend and “create” money.

Money created by a bank through a loan, when spent in the market, may get deposited in another bank which in turn may “create” more money by lending its excess reserves. That loaned money, when spent by the borrower, can get deposited yet another bank, which could lend its excess reserve to other borrowers and so forth. Theoretically speaking, and other things remaining same, this process can continue until there is no excess reserve left with the banking system to lend.

Banks and the Process of Money Creation

Our model to explain the money creation process is based upon the following assumptions:

1. We have a multiple banking system that consists of several banks.

2. The original deposit made by a depositor is $10,000.

3. The required reserve ration set by The Fed is 10 percent.

4. Each bank receiving deposits is able to loan all its excess reserves.

5. All money lent is spent immediately by the borrowers and returns to the banking system as a deposit at some other bank.

6. Interest charged by the banks is not taken into account to keep our model simple.

7. Other assets and liabilities of the banks are not taken into account.

We begin with making a deposit of S10,000 by customers at SunTrust Bank. By keeping 10 percent of the deposit (10,000 x 0.10) $1,000 as its required reserve, it lends the rest—its excess reserve of $9,000 to various borrowers. In the second round, we assume that $9,000 loaned by SunTrust and spent by borrowers get deposited at Wachovia Bank. Now Wachovia Bank after keeping the required reserve of ($9,000 x 0.10) $900 lends the rest. In the third round we assume that ($9,000 - $900) $8,100 of excess reserve is loaned out by Wachovia bank and returns as deposits at Bank of America which has to keep only ($8,100 x 0.10) $810 as a reserve and lends the rest ($8,100 - $810) $7,290 to other borrowers. This process we assume continues until no money is left to be deposited or loaned.

We summarize the above process as below:

Round One

SunTrust Bank

The deposit received = $10,000

Required reserve of 10% 1,000

Excess reserve = 9,000

Money loaned and “created by SunTrust Bank = $9,000

Round Two

Wachovia Bank

The deposit received = $ 9,000

Required reserve of 10% 900

Excess reserve = 8,100

Money loaned and “created by Wachovia Bank = $8,100

Round Three

Bank of America

The deposit received = $ 8,100

Required reserve of 10% 810

Excess reserve = 7,290

Money loaned and “created by Bank of America = $7,290

Total money “created” by the above banks = $24,390

Should we continue with the above process of

receiving deposits and lending their excess

reserves by other banks all over the nation, they

will be able to “create” additional money: = 65,610

Total money the entire banking system

of the U.S. would be able to create = $90,000

One can estimate the amount of money a nation’s banking system is able to create, under the assumptions mentioned above, by using a simple formula called the Money Multiplier. It is explained below:

Money Multiplier (M) is the number of times the original deposit gets multiplied through the demand deposit expansion. It is calculated by dividing 1 with required reserve ratio (R).

M = 1/R = 1/(10/100) = 1/0.10 = 10

Should the required reserve ratio decrease to 5 percent, money multiplier will increase to: 1/.5 = 20. In case it increases to 20%, the money multiplier will fall to 1/.20 = 5.

Thus there is an inverse relationship between the required reserve ratio and the money multiplier. Yet it is important to note that the real life money multiplier is much smaller than the theoretical one for the following reasons:

1. Banks do not and cannot lend all of their excess reserves.

2. Money lent to borrowers is not immediately spent by them.

3. Money borrowed and spent does not necessarily gets re-deposited into another bank.

Such “leakages” from the deposit expansion process slows down and reduces the multiplier. Actually the real life money multiplier is between 2.0 and 3.0. However, using the required reserve ratio is one of the important tools of Fed’s monetary policy. In times of high inflation when too much money is chasing too few goods and services, The Fed may increase the required reserve ratio. When money is tight and prices in general are falling, which is possible but not common, The Fed can lower the required reserve ration.

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How Banks Create Money Out of Thin Air