The preponderant, yet false, representation of how money is created relies on the so-called money multiplier. The idea here is that banks' ability to create money depends on (a) the supply of deposits it receives from customers and (b) the percentage of these loans that must be kept as reserves at the central bank: Say, a bank A has received a deposit from a customer to the tune of $ 100, and the reserve requirement is 20% (of the deposit). Thus, the bank must keep a reserve of $ 20 at the central bank.
The bank is allowed to loan out the remainder, $ 80. So, from a deposit base of $ 100, the bank has created $ 80 of new money. The loan is fully used by the creditor to pay for a house and thus ends up as a deposit by the house-builder, in another bank B. This bank has now a deposit base of $ 80, of which it must keep 20% (= $ 16) as reserves at the central bank. However, the bank is free to loan out $ 64 (= $80 - $ 16).
This process goes on until the deposit base is used up. In the present example, the total amount of money that banks can create through this multiplier effect is $ 100 / 0.2 = $ 500.
If the reserve requirement were 40% , the amount of money newly created by the banks would be only $ 100 / 0.4 = $250. In other words, the lower (higher) the reserve ratio, the larger (smaller) the addition to the money supply created by the banks.
Wrong - Loanable Funds Theory
Unlike many textbooks would have it, it is not true that banks depend on deposits to be able to make loans. It is not the case that first a deposit must be established so that a bank is able to make loan, effectively passing (part of the) deposit on to another client in the form of a loan. Yet, this is the fundamental assumption of the theory of loanable funds.
The truth of the matter is that Banks can create loans, and thus new money, literally out of thin air.
True - Constraints on Banks' Ability to Create New Money
In doing so, of course, the banks still do face a number of constraints that will induce them not to produce money ad libitum.
Most importantly, operating in a competitive environment, banks need to make sure that lending is a profitable operation - the profitability constraint. Any factor compromising this objective will cause banks to adjust lending appropriately. If they fail to show this kind of commercial prudence, there are still regulatory constraints intended to keep banks on a viable course. Also banks, need to take into account credit risk - the risk of loans to default - and liquidity risk - the risk of not being able to honour liabilities due to a momentary lack of funds. Ultimately, credit risk and liquidity risk are subsumed under the profitability constraint, as overwhelming loan defaults and insolvency terminate the ability of a bank to be profitable.
To be continued in Money Creation (2)
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