Money Creation

Did you know that money can be created out of thin air? That's right, all that effort in studying and climbing the corporate ladder for a better wage isn't necessary! Banks create money all the time; they offer loans to borrowers for more money than they actually have! Unfortunately for us, though, only banks can create money, so don't resign from your job. How exactly do they create more money than physically exists? We'll answer that question and more in this explanation of money creation, so read on!

Money Creation Formula and How Money Multipliers Work

Ready to learn the formula for money creation? It is all about how money multipliers work. In our modern economy, there is a multitude of interweaving systems that allow for magical things to occur, like money creation! Money creation is a phenomenon that occurred when banks were in their early founding days. Banks were initially used as convenient places to store assets.

Fig. 1 - Banker storing money in a safe

Bankers realized that the people storing their assets did not come to collect the entirety of their savings, and some rarely withdrew for years. Because bankers had many people's savings piling up, they realized they could put them to use. This became the discovery of the formula for money creation, though there isn't an actual mathematical formula. The formula requires multiple banks to engage in lending activities. This creates a money multiplier that increases the quantity of money more than was previously in circulation.

This gave rise to the concept of lending, providing a loan to a customer in exchange for them paying you back more than the initial loan. By lending out others' money, under the assumption that depositors won't collect it soon, banks were able to create more money than presently existed, an early instance of money creation.

Maybe the concept of money creation doesn't make sense yet; aren't they just giving away other people's money without asking? Yes, technically, they are, but as long as the public believes the bank will make good on its ability to pay when it's needed to, then it can go on creating money. Let's clarify this concept with an example:

In the example above, the bank had an initial deposit made by Meg. The bank then created more money by loaning a portion of it out, which was given to Zarina, who deposited it into the bank. Though the bank has $1,900 deposited into it, it only has $1,000 on hand and $900 owed by Claudette. All banks engage in a process like this. While the bank can't make a loan with the original $1,000 until the loan is paid back, they can make a loan from a percentage of the $900 that Zarina deposited.

Money Creation in the Modern Economy

To understand money creation in the modern economy, we must first establish principles and terms for banking. Banks generally operate on what's known as a fractional reserve banking system. This allows them to maintain a regulated quantity of available funds and give out the rest to borrowers. A reserve requirement is dictated in the United States by the Federal Reserve.

This balance between lending and holding deposits is noted in a sheet, a balance sheet! A balance sheet has two sides, assets and liabilities. Assets are the monetary value of things owned or payments that will be coming in. For banks, assets are predominantly loans and cash on hand. While liabilities are generally deposits made into the bank, that is to say, the bank owes its depositors what they put in.

Because banks provide loans using the money of depositors, technically, they are unable to pay the depositors if they all withdraw at once. If you heard that a bank can't pay people their deposits, would you run to the bank to get your money out before it's gone? That scenario is called a bank run, where a panic occurs that the bank will be unable to pay its depositors, and depositors fear losing their savings. The problem here isn't the bank being able to pay (although partially); the real problem is belief in the bank's ability to pay.

Ironically, it would make sense to believe that the required reserve ratio is meant to prevent a bank run; however, it's not. It's actually meant to mitigate how much risk banks take on. To prevent bank runs, governments establish a form of deposit insurance. In the United States, it's the FDIC (Federal Deposit Insurance Corporation). The FDIC will compensate depositors for $250,000 per bank if a bank is unable to pay what it owes.¹

Money Creation by Banks

Banks engage in money creation by acting as lenders to the public. When individuals or businesses need money to engage in action but can't afford it, they turn to banks. Lending provides a powerful economic tool that enables innovation and investment in production.

Through lending actions like the ones described above, banks allow economic actors to skip financial barriers that would slow their progress. This happens in exchange for dealing with the financial barrier over time or at a later date. So how much do banks actually loan out to spur the economy?

Fig. 2 - Piggy bank finances

A reserve requirement is a tool manipulated by the Federal Reserve to keep the economy stable. However, since the global pandemic in 2020, stability has been rare. The Federal Reserve set a new threshold in response to the pandemic. The Federal Reserve set the reserve requirement to 0%. In the belief that the economy can use all the stimulus it can get to induce money to circulate the economy, the reserve requirement was temporarily removed.³

Assumptions of Money Creation

To view money creation in a vacuum, three main assumptions must be put in place.

1. The reserve ratio for all commercial banks is 10%

2. At the start, all banks are exactly meeting the reserve ratio, with no excess reserves.

3. If any bank acquires excess reserves, it will immediately loan out the entire amount. The borrower will pay a debt, and that debtor will deposit the entirety of the loan into another bank.

Table 1 below demonstrates how an initial deposit of $500 allows banks to loan their excess reserves. When this cycle repeats through multiple holders and banks, the same $500 creates much more economic opportunity.

Table 1 - Money creation across multiple banks example

Table 1 above is an example of money creation by banks. One bank receives an initial deposit, which they loan a percentage out, and each following back does the same, resulting in a money multiplier. The scenario started with only $500; however, after, it was used to create several loans, thereby resulting in much more money in circulation.

\(\hbox{Money Created}=\$450+\$405+\$364.5+\$328.05=\$1,547.55\)

It's important to note that the initial depositors' $500 still exists and is collectible. The money created by the multiplier is in addition to that. Another factor is that this example stops early. Theoretically, the money can move to any number of banks and continue the multiplier effect over and over.