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

  • Utilize the money multiplier formulate to determine how banks create money
  • 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. 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 shown in [link] . 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.

Singleton bank’s balance sheet: receives $10 million in deposits

The assets are reserves ($10 million). The liabilities + net worth are deposits ($10 million).

Singleton Bank is required by the Federal Reserve 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 shown in [link] . 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.

Singleton bank’s balance sheet: 10% reserves, one round of loans

The assets are reserves ($1 million) and loan to hank’s auto supply ($9 million). The liabilities + net worth are deposits ($10 million).

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 a loan has been made. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank 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 [link] shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the rest

First national balance sheet

The assets are reserves (+ $9 million). The liabilities + net worth are deposits (+ $9 million).

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 can be easily used 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 these deposits will be drawn down as Hank’s Auto Supply writes checks to pay its bills. But 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.

Questions & Answers

what is globalization
Nuertey Reply
what is the best definition of economic?
Humble Reply
what is aggregat demand in open economy
Dagim Reply
Aggregate demand is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time.
Bayou
What is the full meaning of GDP
Akinbulejo Reply
gross domestic product
Yanish
Gross Domestic Product
bode
Formula for calculating the percentage of change in price, quantity, price elasticity of demand
Augustina Reply
Given that the elasticity of supply for a good is 2 and the percentage change in price is 45%.What is the percentage change in quantity supplied
Mbe Reply
Please don't understand
Augustina
Explain
Adebisi
ok
Owoeye
percentage change should be 44%
Owoeye
state and explainfour function of a costumer service
Egba Reply
the circular flow model of the economy is a simplification showing how the economy works and the relationship between income,production and spending in the economy as a whole
Anna Reply
It is an idea that show us the way the economy works about their income, production, and spending in the economy
Augustina
what is circular flow
Ntokozo Reply
what is economics?
Dorcas Reply
Economics is defined as the science that study human behaviour as a relationship between ends and scarce means which have alternative uses.
Emmanuella
economics is a social science concerned with the production,distribution, and consumption of goods and services
Michael
Economics as a science studies human behaviour as a relationship between ends and scarce means with alternative use.
Augustina
economics can be defined as social science which studies human behavior as a relationship between ends and scare means which have alternative uses.... Lionel C Robins
Owoeye
in 2021 Amazon reduced the annual subscription fee for its prime membership service which provides free two_day shipping on many goods and other benefits, from $119 to $99. Zoppa consulting, an investment firm estimated that before the price reduction, prime had 62million subscribers globally. If so, what is the arc elasticity of demand for a prime membership.
Joan Reply
Differences between microeconomics and macroeconomics
tatiana Reply
Macroeconomics deal with the economy as a whole.that is an economy affect the firm ,government and the households eg.unemployment, whilst Microeconomics deal with the the decision making of households,firm and government separately.
Amah
Microeconomics is the branch of economic which studies the behaviour of individual households, firms and industries whiles macroeconomic studies the economy as a whole. It looks at the economy from a a broader perspective.
Augustina
what is Economics
Ebem Reply
the branch of knowledge concerned with the production, consumption, and transfer of wealth and has Influence by sociology!!!!
Ajay
Economics is the study of how humans make decisions when they want to fulfil their requirements and desires for goods, services and resources.
Abdullah
Economics is the study how humans make decisions in the faces of scarcity.
Rose
economic is the study of how human make decision in the fact of scarcity.
Toang
Economics is a social science which study human behavior as a relationship between earn and scarce mean which have alternative uses
Juliet
what is market structure
Fatima
market structure in economics depicts how firms are differentiated and categorised based on types of goods they sell and how their operations are affected by external factors and elements.
Nasir
what is economic theory
Madara
what is demand
Gooluck Reply
demand is the willingness to purchase something
Mohamed
demand is the potential ability or williness to purchases something at a particular price at a given period of time..
Ahmed
Demand refers to as quantities of a goods and services in which consumers are willing and able to purchase at a given period of time. Demand can also be defined as the desire backed by ability to purchase .
Fadiga
what is demand
John Reply
is the production of goods in scarcity
David
thanks
John
Demand refers to as quantities of a goods and services in which consumers are willing and able to purchase at a given period of time.
Fadiga
Demand refers to the quantity of goods and services that a consumer is willing and able to buy at a given price over a period of time
Augustina
Do high interest rate in a country increase investment
Alfred
Government sector is the place they can gain more investment but the economy as a whole investment decrease
Augustina

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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