How Banks Expand the Money Supply

[ShackledNation]

It is well accepted that under our current banking system, banks create much of this country's supply of money. Below I will lay out how this actually happens, and welcome criticism or additions (I am simplifying it a bit).

For the sake of example, I will use a single monopoly bank (Bank A). With multiple banks, the ultimate reality doesn't change, but one bank is easier for illustration. The reserve requirement is 10%.

1.
Adam deposits $100 in cash at Bank A, opening a typical checking/debit account. Thus the Bank now has $100 in cash, and Adam has a $100 demand deposit at the bank. Adam's account acts as an IOU from the bank, with the bank owing him $100 in cash should he decide to withdraw it. However, he need not actually spend the cash. He can write checks from his account, or simply swipe a debit card. In fact, Adam never has to use cash at all--the IOUs circulate as money instead, in the form of electronic data or changes on the ledger at the bank in the case of a physical check.

The balance sheet at Bank A looks like this after this initial deposit:

Assets
Cash.............................$100
Total.............................$100

Liabilities
Adam's Demand Despoit....$100
Total.............................$100

The reserve ratio is calculated (based on the simplicity of this example) by dividing cash by demand deposits. In this case it is 100/100=1=100%.

2.
At this point, the bank has a reserve ratio of 100%. The textbook example (not actually what happens in practice) of what happens is that the bank loans out $90, and then that $90 allows for $81 in loans, the resulting deposit allowing for more, etc. This process is repeated until the bank creates $900 in loans. It also typically uses two banks, or multiple banks. To illustrate the textbook example, I will illustrate only what happened after the first $90 loan is made to a woman named Bertha, then the 2nd $81 loan is made to Chris.

After Bertha's Loan:

Assets
Cash.............................$100
Bertha's Loan.................$90
Total.............................$190

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Total.............................$190

After Chris's Loan

Assets
Cash.............................$100
Bertha's Loan.................$90
Chris's Loan...................$81
Total.............................$271

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Chris's Demand Deposit.....$81
Total.............................$271

The reserve ratio is now 100/271, which is 36.9%

3.
The textbook example, however, is not actually what happens in practice. Banks do not loan out 90% of their reserves, and then wait for more deposits to make more loans. They simply create loans first, with the same end result. The Bank of England has admitted such is the way things are, among others. Rather than make single loans and wait for deposits again and again, the bank simply makes loans from the initial deposit until the requirement is at 10%. Here is the result, assuming the bank decides to make 100 loans of $9.

Assets
Cash.............................$100
Single Loan....................$9 (times 100)
Total.............................$1000

Liabilities
Adam's Demand Despoit....$100
Single Demand Deposit......$9 (times 100)
Total.............................$1000

And there you have it. Money is created through the mere issuance of loans under a fractional reserve banking system.

 

[R.C. Christian]

Read "Modern Money Mechanics" recently?

 

[eagle1462010]

I've fought the Fractional Banking system with many on this board.

Good Luck. They aren't going to listen.

Remember the word NOTIONAL as it expands to Derivatives.

Warning Warning Danger Will Robinson.

 

[eagle1462010]

This is one of the more recent battles over this stuff.

http://www.usmessageboard.com/politics/362735-should-the-federal-reserve-be-abolished.html

 

[ShackledNation]

Read "Modern Money Mechanics" recently?

No, never. I don't ascribe to MMT whatsoever.

 

[R.C. Christian]

Read "Modern Money Mechanics" recently?

No, never. I don't ascribe to MMT whatsoever.

I know, I was just messing with you a little bit.

I used to be the sys ad for Mortgage company at a large bank, and sys ad for wire transfers and a DBA at large, privately owned bank. I'm not proud of those five years.

 

[TakeAStepBack]

I've fought the Fractional Banking system with many on this board.

Good Luck. They aren't going to listen.

Remember the word NOTIONAL as it expands to Derivatives.

Warning Warning Danger Will Robinson.

Of course. Because protective interests have kept the confidents.

 

[ShackledNation]

Read "Modern Money Mechanics" recently?

No, never. I don't ascribe to MMT whatsoever.

I know, I was just messing with you a little bit.

I used to be the sys ad for Mortgage company at a large bank, and sys ad for wire transfers and a DBA at large, privately owned bank. I'm not proud of those five years.

Haha ok.

What a job that must have been lol.

 

[Mad Scientist]

"It came from Jekyl Island" is the book that woke me up. No going back now!

Bill Still's "Money Masters" is a great documentary about Banking.

 

[Kimura]

It is well accepted that under our current banking system, banks create much of this country's supply of money. Below I will lay out how this actually happens, and welcome criticism or additions (I am simplifying it a bit).

For the sake of example, I will use a single monopoly bank (Bank A). With multiple banks, the ultimate reality doesn't change, but one bank is easier for illustration. The reserve requirement is 10%.

1.
Adam deposits $100 in cash at Bank A, opening a typical checking/debit account. Thus the Bank now has $100 in cash, and Adam has a $100 demand deposit at the bank. Adam's account acts as an IOU from the bank, with the bank owing him $100 in cash should he decide to withdraw it. However, he need not actually spend the cash. He can write checks from his account, or simply swipe a debit card. In fact, Adam never has to use cash at all--the IOUs circulate as money instead, in the form of electronic data or changes on the ledger at the bank in the case of a physical check.

The balance sheet at Bank A looks like this after this initial deposit:

Assets
Cash.............................$100
Total.............................$100

Liabilities
Adam's Demand Despoit....$100
Total.............................$100

The reserve ratio is calculated (based on the simplicity of this example) by dividing cash by demand deposits. In this case it is 100/100=1=100%.

2.
At this point, the bank has a reserve ratio of 100%. The textbook example (not actually what happens in practice) of what happens is that the bank loans out $90, and then that $90 allows for $81 in loans, the resulting deposit allowing for more, etc. This process is repeated until the bank creates $900 in loans. It also typically uses two banks, or multiple banks. To illustrate the textbook example, I will illustrate only what happened after the first $90 loan is made to a woman named Bertha, then the 2nd $81 loan is made to Chris.

After Bertha's Loan:

Assets
Cash.............................$100
Bertha's Loan.................$90
Total.............................$190

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Total.............................$190

After Chris's Loan

Assets
Cash.............................$100
Bertha's Loan.................$90
Chris's Loan...................$81
Total.............................$271

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Chris's Demand Deposit.....$81
Total.............................$271

The reserve ratio is now 100/271, which is 36.9%

3.
The textbook example, however, is not actually what happens in practice. Banks do not loan out 90% of their reserves, and then wait for more deposits to make more loans. They simply create loans first, with the same end result. The Bank of England has admitted such is the way things are, among others. Rather than make single loans and wait for deposits again and again, the bank simply makes loans from the initial deposit until the requirement is at 10%. Here is the result, assuming the bank decides to make 100 loans of $9.

Assets
Cash.............................$100
Single Loan....................$9 (times 100)
Total.............................$1000

Liabilities
Adam's Demand Despoit....$100
Single Demand Deposit......$9 (times 100)
Total.............................$1000

And there you have it. Money is created through the mere issuance of loans under a fractional reserve banking system.

The BOE information simply points out what post-Keynesians/MMT has been saying for years: loans create deposits. The money multiplier is pretty much a defunct idea. In other words, we really don't have a fractional reserve system, at least operationally or how some of the textbooks explain it.

 

[dilloduck]

I lend my money to a bank at .90 % APR. They appreciate that.

 

[ShackledNation]

It is well accepted that under our current banking system, banks create much of this country's supply of money. Below I will lay out how this actually happens, and welcome criticism or additions (I am simplifying it a bit).

For the sake of example, I will use a single monopoly bank (Bank A). With multiple banks, the ultimate reality doesn't change, but one bank is easier for illustration. The reserve requirement is 10%.

1.
Adam deposits $100 in cash at Bank A, opening a typical checking/debit account. Thus the Bank now has $100 in cash, and Adam has a $100 demand deposit at the bank. Adam's account acts as an IOU from the bank, with the bank owing him $100 in cash should he decide to withdraw it. However, he need not actually spend the cash. He can write checks from his account, or simply swipe a debit card. In fact, Adam never has to use cash at all--the IOUs circulate as money instead, in the form of electronic data or changes on the ledger at the bank in the case of a physical check.

The balance sheet at Bank A looks like this after this initial deposit:

Assets
Cash.............................$100
Total.............................$100

Liabilities
Adam's Demand Despoit....$100
Total.............................$100

The reserve ratio is calculated (based on the simplicity of this example) by dividing cash by demand deposits. In this case it is 100/100=1=100%.

2.
At this point, the bank has a reserve ratio of 100%. The textbook example (not actually what happens in practice) of what happens is that the bank loans out $90, and then that $90 allows for $81 in loans, the resulting deposit allowing for more, etc. This process is repeated until the bank creates $900 in loans. It also typically uses two banks, or multiple banks. To illustrate the textbook example, I will illustrate only what happened after the first $90 loan is made to a woman named Bertha, then the 2nd $81 loan is made to Chris.

After Bertha's Loan:

Assets
Cash.............................$100
Bertha's Loan.................$90
Total.............................$190

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Total.............................$190

After Chris's Loan

Assets
Cash.............................$100
Bertha's Loan.................$90
Chris's Loan...................$81
Total.............................$271

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Chris's Demand Deposit.....$81
Total.............................$271

The reserve ratio is now 100/271, which is 36.9%

3.
The textbook example, however, is not actually what happens in practice. Banks do not loan out 90% of their reserves, and then wait for more deposits to make more loans. They simply create loans first, with the same end result. The Bank of England has admitted such is the way things are, among others. Rather than make single loans and wait for deposits again and again, the bank simply makes loans from the initial deposit until the requirement is at 10%. Here is the result, assuming the bank decides to make 100 loans of $9.

Assets
Cash.............................$100
Single Loan....................$9 (times 100)
Total.............................$1000

Liabilities
Adam's Demand Despoit....$100
Single Demand Deposit......$9 (times 100)
Total.............................$1000

And there you have it. Money is created through the mere issuance of loans under a fractional reserve banking system.

The BOE information simply points out what post-Keynesians/MMT has been saying for years: loans create deposits. The money multiplier is pretty much a defunct idea. In other words, we really don't have a fractional reserve system, at least operationally or how some of the textbooks explain it.

We do have a fractional reserve system--banks do still hold reserves--the reserve requirement is just not a very good limit. Even with no reserve requirement, banks would be keeping a certain percentage of deposits as reserves. For the past several years, for example, banks have been given more reserves but have not expanded lending significantly.

 

[oldfart]

The BOE information simply points out what post-Keynesians/MMT has been saying for years: loans create deposits. The money multiplier is pretty much a defunct idea. In other words, we really don't have a fractional reserve system, at least operationally or how some of the textbooks explain it.

From an individual bank's viewpoint, a loan immediately creates a demand deposit. But as the borrower disperses that money, the demand deposits shift to other banks. If some of those other banks decide to increase their reserves with the shifted funds, the old "money multiplier" goes down. In the extreme case where all other banks do this, the loan has the effect, not of increasing the money supply, but of shifting excess bank reserves from the original bank to other banks.

So loans create deposits when the system as a whole does not hoard reserves. Since about 98% of of increased reserves to the system go to excess reserves rather than being lent out, there is little stimulative effect to ordinary monetary policy.

A similar argument applies to physical investment. Businesses which have funds made available, either through tax credits or tax cuts or low interest rates, still do not invest if they see no rise in demand for their product. Thus businesses tend to hoard cash just as banks do if they do not see a way to invest it more profitably than financial assets. The marginal rate of return on excess inventory is generally close to zero.

 

[EdwardBaiamonte]

, banks would be keeping a certain percentage of deposits as reserves.

and they do, but what does it matter? There is insurance and FDIC and Fed to bail them out should they get into trouble.

 

[ShackledNation]

, banks would be keeping a certain percentage of deposits as reserves.

and they do, but what does it matter? There is insurance and FDIC and Fed to bail them out should they get into trouble.

Sure. But that does not make our system any less of a fractional-reserve one. The best way to describe it would be fractional-reserve banking with the government subsidizing the risks and keeping the system afloat. Competing banks are cartelized by the Federal Reserve to ultimately act as one big bank, preventing them from destroying each other.

The system is truly a monstrosity.

 

[EdwardBaiamonte]

, banks would be keeping a certain percentage of deposits as reserves.

and they do, but what does it matter? There is insurance and FDIC and Fed to bail them out should they get into trouble.

Sure. But that does not make our system any less of a fractional-reserve one. The best way to describe it would be fractional-reserve banking with the government subsidizing the risks and keeping the system afloat. Competing banks are cartelized by the Federal Reserve to ultimately act as one big bank, preventing them from destroying each other.

The system is truly a monstrosity.

well sort of but looking back it would have been so easy to avoid the housing collapse-right? So now the Fed and banking industry have experience with runs, deflation, inflation, QE, and bubbles. That may be the entire universe in which case we are home free in terms of future central banking problems.

 

[Kimura]

It is well accepted that under our current banking system, banks create much of this country's supply of money. Below I will lay out how this actually happens, and welcome criticism or additions (I am simplifying it a bit).

For the sake of example, I will use a single monopoly bank (Bank A). With multiple banks, the ultimate reality doesn't change, but one bank is easier for illustration. The reserve requirement is 10%.

1.
Adam deposits $100 in cash at Bank A, opening a typical checking/debit account. Thus the Bank now has $100 in cash, and Adam has a $100 demand deposit at the bank. Adam's account acts as an IOU from the bank, with the bank owing him $100 in cash should he decide to withdraw it. However, he need not actually spend the cash. He can write checks from his account, or simply swipe a debit card. In fact, Adam never has to use cash at all--the IOUs circulate as money instead, in the form of electronic data or changes on the ledger at the bank in the case of a physical check.

The balance sheet at Bank A looks like this after this initial deposit:

Assets
Cash.............................$100
Total.............................$100

Liabilities
Adam's Demand Despoit....$100
Total.............................$100

The reserve ratio is calculated (based on the simplicity of this example) by dividing cash by demand deposits. In this case it is 100/100=1=100%.

2.
At this point, the bank has a reserve ratio of 100%. The textbook example (not actually what happens in practice) of what happens is that the bank loans out $90, and then that $90 allows for $81 in loans, the resulting deposit allowing for more, etc. This process is repeated until the bank creates $900 in loans. It also typically uses two banks, or multiple banks. To illustrate the textbook example, I will illustrate only what happened after the first $90 loan is made to a woman named Bertha, then the 2nd $81 loan is made to Chris.

After Bertha's Loan:

Assets
Cash.............................$100
Bertha's Loan.................$90
Total.............................$190

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Total.............................$190

After Chris's Loan

Assets
Cash.............................$100
Bertha's Loan.................$90
Chris's Loan...................$81
Total.............................$271

Liabilities
Adam's Demand Despoit....$100
Bertha's Demand Deposit...$90
Chris's Demand Deposit.....$81
Total.............................$271

The reserve ratio is now 100/271, which is 36.9%

3.
The textbook example, however, is not actually what happens in practice. Banks do not loan out 90% of their reserves, and then wait for more deposits to make more loans. They simply create loans first, with the same end result. The Bank of England has admitted such is the way things are, among others. Rather than make single loans and wait for deposits again and again, the bank simply makes loans from the initial deposit until the requirement is at 10%. Here is the result, assuming the bank decides to make 100 loans of $9.

Assets
Cash.............................$100
Single Loan....................$9 (times 100)
Total.............................$1000

Liabilities
Adam's Demand Despoit....$100
Single Demand Deposit......$9 (times 100)
Total.............................$1000

And there you have it. Money is created through the mere issuance of loans under a fractional reserve banking system.

The BOE information simply points out what post-Keynesians/MMT has been saying for years: loans create deposits. The money multiplier is pretty much a defunct idea. In other words, we really don't have a fractional reserve system, at least operationally or how some of the textbooks explain it.

We do have a fractional reserve system--banks do still hold reserves--the reserve requirement is just not a very good limit. Even with no reserve requirement, banks would be keeping a certain percentage of deposits as reserves. For the past several years, for example, banks have been given more reserves but have not expanded lending significantly.

Banks don't lend out reserves, except to each other in the fed funds market. Reserves are simply used as an interbank clearing mechanism. In other words, banks don't utilize reserves for making loans (banks lend out their own deposits, which are the result of keystroke entries). It's critical to realize that banks cannot cause reserves at the FED to decrease by lending them out to their customers. This simply cannot happen because lending isn't part of the equation. If we assume that the public doesn't change their demand preferences for cash and the government sector doesn't make any net payments to the private sector (both of which are beyond the control of banks or the FED), banks reserves must remain at the FED.

 

[EdwardBaiamonte]

It is well accepted that under our current banking system, banks create much of this country's supply of money.

it's much more accurate to say the banks do as the Fed
wishes in order that the country maintains a stable money supply.

 

[eagle1462010]

 

[ShackledNation]

The BOE information simply points out what post-Keynesians/MMT has been saying for years: loans create deposits. The money multiplier is pretty much a defunct idea. In other words, we really don't have a fractional reserve system, at least operationally or how some of the textbooks explain it.

We do have a fractional reserve system--banks do still hold reserves--the reserve requirement is just not a very good limit. Even with no reserve requirement, banks would be keeping a certain percentage of deposits as reserves. For the past several years, for example, banks have been given more reserves but have not expanded lending significantly.

Banks don't lend out reserves, except to each other in the fed funds market. Reserves are simply used as an interbank clearing mechanism. In other words, banks don't utilize reserves for making loans (banks lend out their own deposits, which are the result of keystroke entries). It's critical to realize that banks cannot cause reserves at the FED to decrease by lending them out to their customers. This simply cannot happen because lending isn't part of the equation.

Absolutely correct.

If we assume that the public doesn't change their demand preferences for cash and the government sector doesn't make any net payments to the private sector (both of which are beyond the control of banks or the FED), banks reserves must remain at the FED.

I think I see what you are saying there. You mean if the bank has, say, $5 in physical cash at the bank (which is enough to meet daily demand for cash withdrawals) and $95 in reserves at the Fed, unless people start demanding more cash than the $5 can accommodate the bank will not deduct from their account at the Fed to hold more cash. I suppose that is true. I don't see anything stopping banks from adding to their cash reserves, though. They could just be hoarding cash for whatever reason. Not a smart policy, but there is nothing that says they must only have enough cash in their vaults to meet daily demands.

As for net payments, I suppose I would say the same. Not sure what the point of mentioning this last bit is though.