Friday, February 6, 2009

Do banks create money?

(This is Tuesday's post, delayed due to midterms.)

There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.

The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.

Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.

Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:

"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"

The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.

1 comment:

Chris said...

If I understand you correctly:

1. banks only loan depositors money.
2. as this money is lent and then deposited in different banks and then
lent out again (in smaller amounts based on the reserve rate) the claims
on funds that depositors have increases.
3. In spite of the increase in claims on deposits the actual deposits
remain constant.

My question is how does this really increase the money supply? Is it that
people can pay for things with their claims rather than actual deposits?
It would seem to me that for the money supply to actually increase the
market would have to allow for monetary exchanges (in the form of demands
on deposits) that exceed the amount of actual deposits. Is this what you
are saying?

In light of your understanding of banking would you say that Secretary of the Treasury under Eisenhower was incorrect when he said:

[W]hen a bank makes a loan, it simply adds to the borrower's deposit
account in the bank by the amount of the loan. The money is not taken
from anyone else's deposit; it was not previously paid in to the bank
by anyone. It's new money, created by the bank for the use of the

Robert B. Anderson, Secretary of the Treasury under Eisenhower, said this in an interview reported in the August 31, 1959 issue of U.S. News and World Report.