Banks create money through fractional reserve banking. This involves lending out a portion of customers' deposits. Here is a simplified explanation of how banks create money:
Deposits: When individuals or businesses deposit money into their bank accounts, these funds become part of the bank's reserves. Reserves are funds held by a bank to meet withdrawal requests and fulfill regulatory requirements.
Reserve Requirement: Banks are required by regulatory authorities to hold a certain percentage of their deposits as reserves. This is known as the reserve requirement. The reserve requirement varies by country and is typically a fraction of the total deposits.
Lending and Fractional Reserve: Banks can lend out a portion of deposits, keeping only a fraction of the reserves. For example, if the reserve requirement is 10% and a bank receives a deposit of $1,000, it would keep $100 (10% of $1,000) as reserves and can lend out $900.
Money Creation: When a bank lends money, it does not transfer deposits from one account to another. Instead, it creates capital money in the form of a loan. The borrower receives the loan amount in their account, increasing the overall money supply in the economy. Simultaneously, the borrower becomes indebted to the bank, creating a new liability for the bank.
Circulation and Re-deposit: The borrower can use the loaned money to make purchases or pay off debts to other individuals or businesses. These transactions often involve checks, electronic transfers, or other means that result in money being redeposited in another bank. This process continues, allowing multiple banks to create money based on the initial deposit.
Reserve Maintenance: Banks need to ensure they maintain enough reserves to meet withdrawal demands from customers. They may do this by holding a portion of loan repayments as reserves. They may also borrow from other banks or the central bank to fulfill their reserve requirements.
It is imperative to note that the total amount of money created by the banking system depends on the reserve requirement. In addition, it depends on borrowers' willingness to borrow. Bank money creation contributes to the expansion of the money supply, which has implications for economic activity, inflation, and monetary policy.