Banks Money Views

Toys & Games

These readings introduce you to one of the mysteries of macroeconomics, that banks create the money of modern economic systems. The idea of banks creating money sounds strange to someone who thinks of money as gold or silver. However, for several centuries now most money has been in the form of bank debt. A checking account is nothing more than money that the bank owes you, and paper money represents something that the Federal Reserve System owes you. (Try to collect this debt from the Federal Reserve, though, and see what you get.) When one sees the creation and destruction of money as the creation and destruction of bank debt, the process is less mysterious.

These readings explain how bank-debt money evolved from commodity money and how transactions in the banking system can be analyzed using balance sheets. They explain how checks clear through the system, and how in the process of trying to maximize the return on their assets, banks create money. Thus, money creation is a side-effect of banking. Finally, we look at how central banks control the system of money creation in modern economies.

The funny thing about how a bank works is that it functions because of our trust. We give a bank our money to keep it safe for us, and then the bank turns around and gives it to someone else in order to make money for itself. Banks can legally extend considerably more credit than they have cash. Still, most of us have total trust in the bank's ability to protect our money and give it to us when we ask for it.

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.