How Banks Create Money!

The Fundamental Accounting Equation Net Worth = Assets - Liabilities  Assets –What is owned!  Liabilities-What is owed!  Net worth – The value of the company Rewritten: Assets = Net Worth + Liabilities

The T- account* (a balance sheet) Assets Liabilities Net Worth *both sides have to equal each other

Let’s create a bank. Remember banks are businesses and as such make profits. They are also organized like business and can raise money in similar fashions. For our bank, the Fifth National, lets assume, ceteris paribus, we sell stock and raise $1,000,000. We will use this money to fund the purchase of property, the building of the bank and the furniture and capital necessary for our bank to operate. Our balance sheet will look like this:

The Fifth National Buildings $1,000,000 Net Worth $1,000,000 We are in balance, and the bank is now ready to open.

The Fifth National Our friends and neighbors decide that we will be a good place to keep their money and they deposit $100,000. $100,000 DD TR $100,000 DD stands for Demand Deposits which is another way of saying Checking accounts TR stands for Total Reserves and represents Excess Reserves (ER) and Required Reserves (RR)

The Federal Reserve Bank has as one of its functions, the setting of the Reserve Ratio. The Reserve Ratio is the percentage of Demand Deposits that the bank must maintain at all times. (I want to emphasize it is percentage of Demand Deposits and not Reserves) In our little scenario we will assume that the Reserve Ratio is 10%; thus our balance sheet will look like this

The Fifth National $100,000 DDRR $10,000 ER 90,000

The ER (Excess Reserves) tells how much money the bank can loan out In this instance that would be..? If you said $90,000 you are right. Let’s make a loan.

The Fifth National $100,000 DD RR $10,000 ER 90,000 Loan 90,000 90,000 DD We would not loan out cash but write a check or possibly deposit the amount in the borrowers account.

Our borrower uses the money to buy a new car. The Jag dealership now deposits the check in their bank.

Plano Bank and Guaranty $90,000 DDRR $ 9,000 ER 81,000 The dealership’s bank’s balance sheet looks like this.

Plano Bank and Guaranty $90,000 DD RR $ 9,000 ER 81,000 ER 81,000 This bank can now lend out $81,000 more and their demand deposits increase by $81,000 This bank can now lend out $81,000 more and their demand deposits increase by $81,000. Loan 81,000 81,000 DD 81,000 DD

Plano Bank and Guaranty is going to want payment of the check from Fifth National. Payment of the check is called clearing the check and is done by sending it to the Federal Reserve Bank, which will then send the check to the Fifth National and demand payment. (In reality the entire transaction takes place at the Fed). The Fifth National Bank’s balance sheet looks like this.

The Fifth National $100,000 DDRR $10,000 ER 0 Loans 90,000 Notice that the check is paid from the Excess Reserves and that the check is no longer owed.

Plano Bank and Guaranty $90,000 DD RR $ 9,000 ER 0 ER 0 Loan 81,000 When the FED cleared the check the balance sheet look like this: The process is repeated until there is no more money to be created.

As can be noted the total money created by these two transactions amounts to $171,000 exceeding the initial deposit. If we continue the process until infinity we will have created even more money. In other words, a multiple of our beginning deposit.

The Money Multiplier Mathematically, the money multiplier can be found by taking the inverse of the reserve ratio. 1 RR In our example, the reserve ratio was 10%, therefore the money multiplier was 10.

Multiplying the initial increase in excess reserves by the money multiplier gives us the total new money created by the banking system. 10 X $90,000 = $900,000 new money created