How money creation really works

Author: Adam Button | Category: Education

Deposits don't create loans, it's the opposite

Deposits don't create loans, it's the opposite
When a highschool teacher or (sadly) a university professor explains the banking system and creation of money it often goes like this:

  1. People deposit money at banks
  2. A portion of that money is held at the institution
  3. The rest is lent out
Essentially, the bank lends out your deposits and the bank never has enough money to pay back depositors. The money is multiplied over time.

The reality is far different. In many ways, it's the opposite. Banks don't need any deposits in order to make loans.

When someone walks into a bank and asks for a loan, what happens is that money is 'created' and the bank creates a matching deposit in the borrower's bank account. When the money is paid back, it is 'destroyed'.

The limits of money creation are mostly prudential. Regulators require banks to hold back a certain amount of capital. This isn't to pay back depositors but to shoulder loan losses.

At the same time, a competitive banking industry pushes loan rates lower, ultimately putting a cap on profitability. Banks will choose not to lend more when the risk of losses outweigh the marginal profits. Historically though, banks have acted recklessly and that's why regulation has increased.

From a macro perspective, the real driver of money creation is bank lending, which is why loan demand is a closely-watched indicator.

The way that central banks can manage this is by setting interest rates. Higher rates cool loan demand, which slows the pace of money creation and ultimately, the pace of inflation and growth.

This is all simplified but it is at the core of how monetary policy and the economy works. The Bank of England has a great pdf explaining it in more detail.

Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy - through the interest rate that it pays on reserves held by commercial banks with the Bank of England
Here's another good explanation from Martin Wolf.
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