Readers Question: Is it right that private banks can create 97% of all new money by lending it into existence, and what effect does this have on inflation and the value of money already in existence?
It is true, that banks can effectively increase the money supply, by lending out say 97% of all deposits.
Example of How Banks can Create Money
- If you deposit £1,000 in the bank. The bank has £1,000 extra deposits (assets).
- Out of this £1,000, the bank may keep only a reserve of 3% (£30).
- This means they can lend out £970 to other people. The bank lends out money because it is more profitable. For example, they can lend to home-owners wishing to get a mortgage. The bank may charge an interest rate of 6% on this mortgage loan. Also, banks may lend to firms wishing to expand.
- However, if a firm gets a loan from the bank, then workers and the bank may then deposit some of this money back in the bank.
- This means that banks will have additional deposits in the future. Therefore, when this £970 gets deposited they can again lend out 97% of the value.
- Therefore, there is a cumulative creation of money from this system of lending out bank deposits.
- The amount of money created depends on the ratio that banks keep in reserve. If they keep 10% of reserves as cash, then the creation of money will be smaller than if they lent out 99% and only kept 1% in reserve.
Example of money creation
- Suppose banks keep a reserve ratio of 10%. (0.1)
- Therefore, if someone deposits $100, the bank will keep $10 as reserves and lend out $90.
- However, because $90 has been lent out – other banks will see future deposits of $90.
- Therefore, the process of lending out deposits can start again.
Note: This example stops at stage 10. In theory, the process can continue for a long time until deposits are fractionally very small.
Banks and Falling Money Supply
In some circumstances, commercial banks may be very reluctant to lend money. Therefore, they increase their reserve ratios and reduce the amount of bank lending. This can lead to a fall in the money supply in the economy.
For example, after the credit crunch of 2008, banks significantly reduced the amount of their lending, leading to a fall in the money supply and decline in bank lending.
Central Bank and the Creation of Money
In some circumstances, a Central Bank like the Bank of England or Federal Reserve may decide to electronically create money in a bid to increase the money supply and boost economic activity.
This is often known as quantitative easing. With quantitative easing
- A central bank decides to electronically create money (they just change the amount of money in their account)
- With this money, they buy bonds from commercial banks.
Therefore in theory,
- Commercial banks see an increase in their cash reserves, which should lead to higher bank lending
- Interest rates on bonds should fall. Lower interest rates should help boost economic activity.
More on Quantitative easing.
Effect on Inflation of Money Supply
If there is an increase in the Money supply, it could cause inflation. If the money supply rises much faster than the long-run trend rate of real output, then inflation is likely to occur.
In practice the money multiplier is less than the inverse of the reserve ratio