How Banks Create Money
Learning Objectives
By the end of this section, you will be able to:
- Explain, using T-account balance sheets, how banks create money
- Evaluate the difference between the orthodox and heterodox approaches to money and banking
In the orthodox approach to banking in the previous section, you learned that banks can expand on a given amount of deposits to create more money than initially existed. From this perspective, money is still a scarce thing–fixed in initial quantity, in the form of deposits at the bank. Heterodox economists conceptualize money as something completely different. From a heterodox perspective, money is in essence an IOU, a relationship between two parties: the creditor (the one owed) and a debtor (the one owing). This alternative way of looking at the what money fundamentally is has far-reaching implications, some of which will be explored in a later chapter. For now, we’ll see that, if money is at its heart an IOU, then banks don’t just expand on an initial sum of money they’ve collected as deposits; they actually create money ‘from thin air’.
Money Creation by a Single Bank
To see how a bank can create money ‘from thin air’ (or ex nihilo), we’ll start over with a hypothetical bank called Singleton Bank and three businesses.
The Bank and the Businesses:
For this example, let’s assume Singleton bank has all the tools a bank needs: a piece of paper and a pen (no deposits are necessary here, nor a pickaxe to mine for gold). Also, the Singleton bank is run for free—that is, it’s not looking to make a profit, just break even—, but it does charge interest to cover the risk of default (that is, borrowers not repaying their loans).
Now suppose three businesspeople, Hank, Rosalita, and Cassandra, each running their own auto parts stores, come to the bank, asking to borrow money so that they can invest in their businesses and pay other expenses. Each businessperson is asking for a loan of $1,000.
The Loans:
After looking into the credit histories of the potential borrowers, the bank determines that the three Hank, Rosalita, and Cassandra are all creditworthy, but estimates that there is a risk of one of these businesses failing. For the bank, this is important because it means one these borrowers won’t be able to repay their loan. Since the bank doesn’t know which one will fail, it will have to charge an interest rate to all three of them that covers the likelihood of one of them defaulting. This works out to an interest rate of 50%, which means each business will borrow $1,000 and agree to repay $1,500.
Calculating Interest for Risk
Here’s how the bank came up with this interest rate:
The number of successfully repaid loans times the dollar amount of each individual loan times (1 plus the necessary interest rate, r) should be sufficient to cover the total loans made. In this case, that means 2*1,000*(1+r)=3,000. Then a little bit of algebraic magic will show that
[latex]r = (3,000/2,000) - 1 = 0.5[/latex]
Which