How Is Money Created ?

We have previously covered the subject of what money is. So now let’s see how it is created.

That’s something I had a hard time understanding the first time it came across since it’s actually not that intuitive.

The money multiplier model

Let’s say that you have some money to deposit in the bank. So you go there and you deposit $1000.  However, since the bank assumes that you probably won’t need all that money back at the same time and because it is legally required of them to keep a certain amount of money — let’s say 10% therefore the bank $100 — in its reserves — that’s called a reserve requirement — it can lend $900 of the money you deposited to someone else who needs a loan — let’s say person A.

Now person A makes a purchase in person B’s shop for let’s say $900. Person B then goes to another bank — bank B — to deposit the cash and bank B keeps 10% of the $900 — which is $90 — and lends the remaining $810 to person C. This process then goes on and on until all the original $1000 is hold in reserves.

However, all these people who have deposited money in the bank can see on their bank statement that exact amount of money even though that is not actually the amount the bank holds in its reserve.

Moreover, even if it is still the same $1000 that is lent over and over again, the sum of the amount of money on each person’s bank statement is way over $1000. Regarding our previous example — and if we consider that person C made an $800 purchase in person D’s account who then put this money in bank C — , the sum equals 1000 + 900 + 800 = $2700.

So now 2700 – 1000 = $1700 were created out of thin air !

Here is a graph that shows how much money this model can create depending on the reserve requirement percentage — in this case we consider that all the money a person has in deposited in the bank.

So this model relies on the reserve requirement since the amount of money created depends on it. However, some countries — like the UK — have a 0% reserve requirement. In the US, it varies from 0 to 10% depending on the amount of money in the accounts of a bank customers.

It can also be a way of controlling the amount of money in the economy. If a government decides to lower the reserve requirement, it pumps money into the economy — by creating more of it. If it decides to increase the reserve requirement, it decreases the amount of money in the economy.

What does it mean if there is no reserve requirement ?

Well, in this case, the amount of money lent never dies down. Indeed, if person A deposits $1000 in bank A, it can lend $1000 to person B and so on.. Therefore, the amount of money created can be limitless.

However, there is something that is called “ capital adequacy requirements ”. Regulatory agencies require banks to hold a certain amount of cash in their reserves in case of emergency. So basically, a bank can not hold zero amount of cash and therefore the amount of money they lend does die down after a while.

Moreover, in countries where reserve requirements are established, capital requirements are added on top.

If there’s anything you would want to add or share, please do so in the comment section :). I am learning as I do these articles so don’t hesitate to correct me if I said something wrong.

Additional resources :

The money multiplier

A deeper explanation of this model above (however, you should consider their balloon model carefully since I have found other resources that say otherwise)

 

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