How Banks Create Money
by: Tanner Larsson
Did you know that banks can “create” money?
The vast majority of people have only the
vaguest idea of how banks and financial institutions in general,
operate. They just go about their lives never understanding what happens
every time they deposit money into their bank.
I guarantee you if they did know what went
on behind the scenes, they would demand much more than the pitiful, if
any, interest rates they are getting now.
Now I’m going to give you a behind the
scenes look at how banks create money.
Currently when banks receive a sum of money,
they are able to lend out ten times that amount. That’s right for every
$1 that comes into the bank, they can lend out $10.This is called the
money multiplier and it is based on the required reserve ratio.
The required reserve ratio is the percentage
of the total deposits the bank recieves that must be held in reserve and
cannot be lent out. The required reserve ratio is determined by the
Federal Reserve Bank (FRB). Whatever is left over after the reserve has
been met can be lent out.
To figure out the current money multiplier,
use the following formula:
1 / Required Reserve Ratio = Money
Below you will find a basic example of how
banks create money, in this example the Federal Reserve Requirement is
10%. That means that the money multiplier is 10, so the banks can lend
out $10 for every dollar they receive.
---- Begin Example ----
John deposits $10,000 into his checking
account at Bank A.
Reserve (10%): $1,000
Lendable Amount: $9,000
Mary borrows $9,000 from Bank A and buys a
car. The car dealer then deposits $9,000 into their account at Bank B.
Reserve (10%): $900
Lendable Amount: $8,100
Mark borrows $8,100 from Bank B and has
surgery. The doctor then deposits $8,100 into his account at Bank C.
Reserve (10%): $810
Lendable Amount: $7,290
Sue borrows $7,290 and shops at Versace.
Versace then deposits $7,290 into their account at Bank D.
Reserve (10%): $729
Lendable Amount: $6,561
Kim borrows $6,561 from Bank D and pays off
her credit card, the Credit Card Company then deposits $6,561 into their
account at Bank E.
Reserve (10%): $656.10
Lendable Amount: $5,904.90
And so on through the system. When M1* is
measured, and the FRB totals the checking account balances in the entire
system, the original $10,000 deposit will have created a total of
$100,000 in deposits system wide.
*M1 = First level of money supply = All
currency held by the public.
---- End Example ----
That in its simplest form is how the banks
create money. Now considering how much money the banks are making off of
every dollar you deposit, does the 0.01% or 0.25% interest rate you’re
getting paid seem fair?
Not to me, but because the general public is
uninformed of this fact of life, the banks and other financial
institutions will continue to reap extraordinary profits from
practically imaginary money.
Copyright © Tanner Larsson
is a veteran entrepreneur and the publisher of the award winning
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This article was
posted on January 30, 2005