27.4 How banks create money

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

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

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

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.