The Economics Journal

I saw a few videos and articles about how banks create money in fractional reserve and disturbed by the whole tone. They showed this as though something illegal or counterintuitive is happening. But, this is not that controversial and the facts were not spelled out properly. How do banks create money actually? We will see some of Economics basics about these.

Fractional Reserve Banking

In a fractional reserve system, banks can loan a big portion of the deposits you keep with them. This is the way the banks makes money. This is in contrast to full reserve banking (doesn’t exist anywhere) where the bank just safely stores your money and whenever you ask back they can open the safe and give it you. The assumption is that not all people will come back asking for their deposits at the same time. Now, how does this increase the overall money supply? Here we call money supply as the sum total of all currency in circulation held by non-banking public + all deposits kept in the bank.

Let us assume banks reserve ratio (how much they should keep as enforced by the law) is 10% and a freshly minted $100 comes into the hand of somebody in the system.

The guy X with $100 goes to the bank and deposits it. Now, bank can loan $90 out of this $100 and keep reserve as $10. Let us say, person Y takes a loan for $90 for paying something, to Z. Z has has this $90 and has to keep it somewhere and he goes into some bank and deposits this $90. Now, the overall money supply of the entire system is $100 (deposits in first bank) + $90 (deposits in second bank) = 190. Then this second bank can loan $81 (keeping $9 as a reserve) and this finally ends with a person A, and this process continues till you cannot divide up the currency anymore.

Wikipedia illustrates a similar example with a reserve ratio of 20%

Total Amount created

Thus, there are two ways of creating money – the original $100 printed by the Mint (money creation) and the amount created by the bank (credit creation).

So, what is the total money supply generated from this. It is simple.

money supply = money minted * 1/reserve ratio.

This 1/reserve ratio is called the money multiplier. Now, this assumes everybody deposits money into the bank, whenever they get it. What if people don’t deposit a portion of their money and keep it as currency? If the person Z in our example didn’t put money into the bank, the money supply would have been stopped at 190. So, here comes the concept of currency drain. As people retain more currency in their wallets the overall money supply is reduced. And sometimes banks also keep reserves more than the required ratio. This is called the excess reserve ratio, if they fear that a lot of people will be coming for their deposits soon.

Thus, accounting for them,

money supply = money base * (1 + c )/(r + e + c)

here c = currency drain, e = excess reserve and r = reserve ratio. c is also in the numerator because having money as currency doesn’t mean money gets wiped out, but only means that it doesn’t get multiplied.

Why money supply is important?

Money supply directly affects inflation. If you have more money going around, people will be tempted to buy more things and this will push the value of prices, if other things are constant. Here are two important equations.

Total economic output, GDP = Money supply * velocity (how fast people spend their money)

Economic output also equals = price levels * total amount of goods produced

Equating them both, we will have price levels = money supply * velocity/goods produced. Thus, if money supply increased or if people spend their money fast, far more than the amount of goods produced, you will have an increase in price levels or inflation. Thus, central banks try to control money supply to maintain inflation and if price levels go too high, they increase bank reserve ratio which in turn reduces the money supply. Velocity typically remains bounded in a narrow range (for US – it is in the range of 1.25 to 2):

Chart source: Wall Street Examiner

Bank Runs

When you retain only a partial amount of money in the reserve, you are always putting yourself to the risk of all depositors coming and knocking your door at the same time. You cannot go to your borrowers and ask for money immediately because typically the loans are of longer term and will not be available on demand. If you have given a 30 year home loan, by law you cannot ask the borrower to repay the principal completely within the 30 years. This can lead to a bank run and a lot of banks have collapsed in the earlier times. That’s why most governments have central banks that regulate the banks to make sure reserves are maintained correctly and if there is a bank run, try to back stop with public money.

Read more:

1. http://www.federalreserveeducation.org/fed101_html/policy/frtoday_depositCreation.pdf
2. http://en.wikipedia.org/wiki/Fractional-reserve_banking
3. ECON 354 Money and Banking

Header image from: http://www.costaricapages.com/panama/blog/wp-content/uploads/2008/03/piggy_bank.JPG