14.4How Banks Create Money

geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help. Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times.

14.4 How Banks Create Money

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Utilize the money multiplier formula to determine how banks create money in an environment of limited reserves
• Analyze and create T-account balance sheets
• Evaluate the risks and benefits of money and banks

Banks and money are intertwined. It is not just that most money is in the form of bank accounts. If banks choose to hold only limited reserves, the banking system can literally create money through the process of making loans. Let’s see how.

Money Creation by a Single Bank

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is in Figure 14.6. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either. FIGURE 14.6Singleton Bank’s Balance Sheet: Receives $10 million in Deposits The Federal Reserve requires Singleton Bank to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers. This change in business plan alters Singleton Bank’s balance sheet, as Figure 14.7 shows. Singleton’s assets have changed. It now has $1 million in reserves and a loan to Hank’s Auto Supply of $9 million. The bank still has $10 million in deposits. FIGURE 14.7Singleton Bank’s Balance Sheet: 10% Reserves, One Round of Loans Singleton Bank lends $9 million to Hank’s Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that it has made a loan. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer will not allow let Hank to walk out of the bank with $9 million in cash. The bank issues Hank’s Auto Supply a cashier’s check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 14.8 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest FIGURE 14.8First National Balance Sheet Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which one can easily use as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously as Hank’s Auto Supply writes checks to pay its bills the deposits will draw down. However, the bigger picture is that a bank must hold enough money in reserves to meet its liabilities. The rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million. Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack’s Chevy Dealership as Figure 14.9 shows. FIGURE 14.9First National Balance Sheet If Jack’s deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 14.10 shows. FIGURE 14.10Second National Bank’s Balance Sheet How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply. LINK IT UP Watch this video (https://openstax.org/l/createmoney) to learn more about how banks create money.

The Money Multiplier and a Multi-Bank System

In a system with multiple banks that are holding only limited reserves, Singleton Bank deposited the initial excess reserve amount that it decided to lend to Hank’s Auto Supply into First National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, institutions determine the amount of money that the system can create by using the money multiplier. This tells us by how many times a loan will be “multiplied” as it is spent in the economy and then re-deposited in other banks. Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is: We then multiply the money multiplier by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation. WORK IT OUT Using the Money Multiplier Formula Using the money multiplier for the example in this text: Step 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10. Step 2. We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply: Step 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.

Cautions about the Money Multiplier

The money multiplier will depend on the proportion of reserves that the Federal Reserve Band requires banks to hold. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that customers are less likely to repay loans when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss. The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. All the money in the economy, except for the original reserves, is a result of bank loans that institutions repeatedly re-deposit and loan. Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low- income countries have what economists sometimes refer to as “mattress savings,” or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline. LINK IT UP Watch a video (https://openstax.org/l/moneymyth) of Jem Bendell discussing “The Money Myth.”

Money and Banks—Benefits and Dangers

Money and banks are marvelous social inventions that help a modern economy to function. Compared with the alternative of barter, money makes market exchanges vastly easier in goods, labor, and financial markets. Banking makes money still more effective in facilitating exchanges in goods and labor markets. Moreover, the process of banks making loans in financial capital markets is intimately tied to the creation of money. However, the extraordinary economic gains that are possible through money and banking also suggest some possible corresponding dangers. If banks are not working well, it sets off a decline in convenience and safety of transactions throughout the economy. If the banks are under financial stress, because of a widespread decline in the value of their assets, loans may become far less available, which can deal a crushing blow to sectors of the economy that depend on borrowed money like business investment, home construction, and car manufacturing. The 2008–2009 Great Recession illustrated this pattern. BRING IT HOME The Many Disguises of Money: From Cowries to Crypto The global economy has come a long way since it started using cowrie shells as currency. We have moved away from commodity and commodity-backed paper money to fiat currency. As technology and global integration increases, the need for paper currency is diminishing, too. Every day, we witness the increased use of debit and credit cards. The latest creation and a new form of money is cryptocurrency. Cryptocurrency is digital currency that is not controlled by any single entity, such as a company or country. In this sense, it is not a fiat currency because it is not issued by a central bank and is not necessarily supported by governments as legal tender. Instead, transactions and ownership are maintained in a decentralized manner, and the value (vis-à-vis, say, the U.S. dollar) is determined primarily by market forces—i.e., supply and demand. Governments can affect the value of a cryptocurrency by regulating its use within their country's boundaries, but in the end, the price of a cryptocurrency comes down to supply and demand. Cryptocurrencies have come a long way since 2009 when Bitcoin was first invented, and the recent two to three years has seen an explosion of different cryptocurrencies being used across the globe. It is important to note that in order to be considered as money, cryptocurrency still needs to satisfy the three requirements: it needs to be valid as a store of value, it needs to be valid as a unit of account, and it must be able to be used as a medium of exchange. While the first two of these requirements can be satisfied easily by expressing the currency in terms of another, such as the U.S. dollar, and through its secure ownership rules, its use as a medium of exchange—to be used to buy and sell goods and services—is more complicated. While cryptocurrencies are used in many illicit transactions, it is less common to see them accepted as forms of payment for regular things like groceries or your rent. Bitcoin is the most popular cryptocurrency, and thus the one most likely to be considered real money since it can be used to purchase the most goods and services. Other popular cryptocurrencies as of early 2022 (in terms of trade volume) are Ethereum and Binance Coin. Many other cryptocurrencies exist, but their more widespread adoption as a medium of exchange is yet to be seen.

Key Terms

ample reserves when banks are holding an amount of reserves significantly above the minimum required amount; generally a choice made by banks during and after the Great Recession asset item of value that a firm or an individual owns asset–liability time mismatch customers can withdraw a bank’s liabilities in the short term while customers repay its assets in the long term balance sheet an accounting tool that lists assets and liabilities bank capital a bank’s net worth barter literally, trading one good or service for another, without using money coins and currency in circulation the coins and bills that circulate in an economy that are not held by the U.S Treasury, at the Federal Reserve Bank, or in bank vaults commodity money an item that is used as money, but which also has value from its use as something other than money commodity-backed currencies dollar bills or other currencies with values backed up by gold or another commodity credit card immediately transfers money from the credit card company’s checking account to the seller, and at the end of the month the user owes the money to the credit card company; a credit card is a short-term loan debit card like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller demand deposit checkable deposit in banks that is available by making a cash withdrawal or writing a check depository institution institution that accepts money deposits and then uses these to make loans diversify making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms double coincidence of wants a situation in which two people each want some good or service that the other person can provide fiat money has no intrinsic value, but is declared by a government to be the country's legal tender financial intermediary an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return liability any amount or debt that a firm or an individual owes limited reserves when banks are holding an amount of reserves that are at or only slightly above the minimum required amount; generally a choice made by banks before the Great Recession M1 money supply a narrow definition of the money supply that includes currency and checking accounts in banks, and to a lesser degree, traveler’s checks. M2 money supply a definition of the money supply that includes everything in M1, but also adds savings deposits, money market funds, and certificates of deposit medium of exchange whatever is widely accepted as a method of payment money whatever serves society in four functions: as a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. money market fund the deposits of many investors are pooled together and invested in a safe way like short- term government bonds money multiplier formula formula used to determine the total amount of M1 money supply created in the banking system; equal to 1/reserve ratio net worth the excess of the asset value over and above the amount of the liability; total assets minus total liabilities payment system helps an economy exchange goods and services for money or other financial assets reserves funds that a bank keeps on hand and that it does not loan out or invest in bonds savings deposit bank account where you cannot withdraw money by writing a check, but can withdraw the money at a bank—or can transfer it easily to a checking account