Contrary to popular belief, most money is not created on government printing presses. When banks accept deposits and make loans, money is created. To understand how this works, you have to know some accounting principles. (I’ll try to make this as painless as possible, I promise.)
A balance sheet compares the assets a bank owns with the liabilities it owes. If you have never taken a course in accounting, then you might not be familiar with the following equation: Assets = Liabilities + Stockholder’s Equity. If you haven’t fallen asleep yet, please bear with me through the following explanation:
Because assets equal liabilities plus stockholder’s equity, a bank with (for example) $1 million in assets and $500,000 in liabilities would have $500,000 in stockholder’s equity. Additionally, changes in a bank’s liabilities can create an equal change in a bank’s assets. For example, if customers deposit $100,000 in a bank (a liability), then the bank’s reserves increase by $100,000 (an asset). On the other hand, if customers withdraw $25,000, then bank reserves are reduced by $25,000 as well.
Banks are required by law to maintain capital requirements. This is actual cash money (capital) that a bank must keep on hand to conduct its operations, usually a ratio that is related to the riskiness of its loans (riskier loans create greater capital requirements). The purpose of the capital requirement is to ensure that the bank is able to pay depositors if some of the bank’s borrowers are unable to repay their loans. Capital requirements also mean that banks have a vested interest in making sound loans.
What exactly are bank reserves? Reserves are funds that are either available for lending or held against checkable deposits. The reserves available for lending are called excess reserves and those held against checkable, but not savings, deposits are called required reserves (see sidebar, “Capital Requirements Defined”). Required reserves are held either as cash in the bank’s vault or are deposited in the bank’s reserve account with the Fed.
In the United States, the required reserve ratio, set by the Fed, is the percentage of checkable deposits that a bank cannot lend. For large banks, the required reserve ratio is 10%. Therefore, assuming a 10% required reserve ratio, if customers deposit $100,000 into checking accounts, required reserves increase by $10,000 and excess reserves increase by $90,000. When the economy is healthy, banks tend to lend out all excess reserves. Why? Banks profit by charging interest on loans, so they have a strong incentive to maximize the amount they lend.
Money is created when the bank continues to lend its excess reserves. For example, a $100,000 checking deposit generates an increase in excess reserves of $90,000. If the bank lends the full $90,000 to a customer who in turn purchases a recreational vehicle, the seller of the vehicle might then deposit the $90,000 in the bank.
What happened to the checkable deposit balance in the bank? It grew from $100,000 to $190,000 in a short period of time. Money was created. The process does not stop with just this transaction. You can see that the bank now has $90,000 in new deposits. The bank will hold 10% as required reserve and lend the rest. The proceeds of the loan will be re-deposited, and now $81,000 of new money is created. This process continues until all excess reserves are loaned out.
Economists are able to estimate the growth in the money supply with the money multiplier. While this may sound like a gizmo you’d like to have in your basement, it’s basically a formula: the number one divided by the required reserve ratio multiplied by the excess reserve.
Given that the reserve ratio is 10%, the money multiplier is 10 (if the reserve ratio were 25%, then the money multiplier would be 4). If $30,000 is deposited into a checking account, economists would predict that the money supply will grow by a maximum of $270,000 ([$30,000 – $3,000] × 10).
The accuracy of the money multiplier as a predictor of the money supply is constrained by two factors. The multiplier assumes that banks lend all excess reserves and that the loans are all re-deposited. If either of these assumptions does not hold, the multiplier effect is reduced. Many Americans hold onto their cash, and that acts as a limit to the money multiplier.
Just as easily as money is created, money can also be destroyed (the horror!). Remember, money is created when customers make deposits and banks make loans. Money is destroyed when customers withdraw balances and pay off loans. Consider the following example. If Maria writes a $10,000 check to pay off her car loan, checkable deposits are reduced by $10,000, and the money supply shrinks. What’s good for you personally may not be so good for the economy.