Do Banks Create Money?

(5-10 Minute Read Time)

Commercial or high street banks as found in most developed economic are an essential function in everyday life for most people. We open bank accounts and use debit/credit cards daily to close transactions, paying for both goods and services. It is for this reason everyone should possess a core understanding of how the most common banking systems work, and the role banks play in the expansion of monetary (money) supply.

As one may expect, ‘do banks create money’ is not a simple yes or no question, and the answer is grounded in the banking system used within the nation of focus. Therefore, when presented with the above question the two main approaches to banking should be considered, 100% reserve banking and fractional-reserve banking.

Before advancing in any detail, it would first be beneficial to introduce some key banking terms.
Demand Deposits – Demand deposits are all cash deposits, paid by everyday customers into bank accounts.
Bank Reserves – Bank reserves are the total balance a bank will hold in cash. The reserve balance is also known as the banks liquidity. Managing this pool of capital ensures that depositors can withdraw cash without formal notice. Typically, banks are subject to reserve requirements, a minimum reserve level enforced by regulators, ensuring institutions are able cope with variations in depositor withdrawal demand.
Money Supply ­­­- Money supply is the total quantity of money (cash) within an economy at any specific time, this is calculated by adding the value of all cash and demand deposits together.
Monetary Base – Monetary base and money supply are not the same nor equal, the monetary base refers to the total amount of currency created by the central bank. Calculated by finding the sum of cash + bank reserves.

As mentioned earlier there are two common approaches to banking:
100% Reserve Banking – which requires banks to hold 100% of their customer deposits as reserves, meaning deposits = reserves. A system in which no additional money is created.
Fractional-Reserve Banking – The fractional-reserve system allows banks to hold only a percentage of the deposits made with them as reserves. Under such as system banks are able to increase money supply through the process explained below.

So how does the fractional-reserve system create money?
In the modern world, most banks will operate under the more complicated fractional-reserve system, meaning that when banks take deposits from customers, they only hold a fraction as reserves. When a bank only holds a fraction of a deposit in reserves they are left with a residual (leftover) cash balance, which it will use to make loans to other customers, which in turns begins the process of money supply expansion. This is often better understood using some simple numerical examples.

Imagine an economy that starts with a £1,000 monetary base, for simplicity this is owned by a single consumer named Joe.

Here we introduce the first bank, Bank A, which operates a 10% reserve requirement.
If Joe deposits their money with Bank A, deposits rise from £0 to £1,000
The 10% reserve requirement means the bank only holds £100 of Joe’s deposits as reserves.
This allows the bank to use the additional £900 to make loans to other customers (Sam).
Therefore after the initial £1,000 deposit is made in Bank A, total money supply increases to £1,900.
When broken down Joe still has £1,000 in deposited cash, while Sam has a £900 loan.
 
As more banks are added to the system the effect snowballs, to further illustrate this a second bank, Bank B can be added to the economy. Once again for simplicity, it can be assumed Bank B has an identical reserve requirement of 10%.

If Sam chooses to deposit their £900 cash balance in Bank B, then deposits increase from £0 to £900. Of this £900 the bank holds £90 as reserves and lends the additional £810 to a third consumer. Therefore, the initial money supply of £1,000 has made its way through two banks, causing total supply to increase to £2,710.

The difference in the monetary base and final money supply is known as the money multiplier effect, demonstrating the role banks play in magnifying the effect of changes in the monetary base on money supply.