Perhaps the most essential concept to understand economics, and the global economy is to understand how many is created. It is quite ironic that the concept of money creation is often shrouded in complexity and misunderstanding. The money multiplier theory is generally used to explain money creation but this theory is in fact wrong. We will dive in to the money multiplier theory, and continue by explaining how commercial banks actually create money.
The money multiplier theory describes how an initial deposit leads to a greater final increase in the total money supply. The theory holds that central banks create money which enters the economy, once it enters the economy participants deposit cash to Commercial banks who partake in fractional reserve banking. Fractional Reserve Banking holds that commercial banks must keep a fraction of all deposits at a Central Bank and they are free to lend out the rest of the deposits to other people. The idea behind the money multiplier is when banks loan money, individuals deposit the money at the banks, forcing other banks to keep some of the capital fractionally reserved but allowing them to be free to provide loans with the rest.
Imagine you have a pot of honey (this is like the money the bank has), and you want to make sure there's enough honey for everyone in your family. You can't make more honey, but you can share it in a special way so that everyone feels like they have a full pot.
So, you give some honey to your mom and tell her she needs to keep a little bit, but she can share the rest with others. Your mom takes a spoonful of honey, keeps a little, and then gives the rest to your dad. Your dad does the same thing; he keeps a spoonful and passes the pot on. This goes on and on with your brothers, sisters, and friends.
Whilst this presents a compelling story, research has shown that the Money Multiplier theory does not work for money creation, however, economic teachings lag and this story is still perpetuated in educational institutes. So what is the new story?
To understand how money is created we must understand the actual process that occurs when commercial banks lend money. When a customer requests a loan from a bank two things happen.
Firstly, it is recorded that a customer owes the bank $X (the amount loaned) + x%(interest rate) to be paid back by a certain date.
Secondly, it is recorded that the bank owes the customer the exact money of the loan, which the customer can retrieve at any moment. Banks are willing to accept this trade due to the interest received by banks on loans.
Now the majority of the money that enters the financial system comes from this debt that banks create. This results in two major differences from the money multiplier theory; firstly the chronology of the process of money creation, and next is the constraints of money creation.
Money multiplier theory holds that central banks create money which ends up in the economy once people bring cash to a bank and the banks lends a portion of this. In reality money is created when debt is issued by a bank once someone requests a loan. Central banks aren’t needed for the creation of money and instead it is the interest on debt that creates money.
In the money multiplier theory money creation is constrained by how much money banks have in their reserves, as this is all they are allowed to lend, however, banks are not constrained when issuing loans, at least not by their reserves. Instead the main constraint faced by banks with regards to money creation is that of customer demand. Banks can only loan money if there is demand for money.
Without demand for loans, banks cannot issue loans, and as such cannot receive interest. This is why central banks typically promote low interest rates, and why money creation decreases during high interest rate environments (despite popular belief quantitative easing which occurs during high interest environments is not akin to money creation).
Another limitation to money creation by commercial banks is that law requires banks to keep a certain amount of capital to loan ratio which varies but is usually around 5-10%.
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