How Do Commercial Banks Create Money?

How commercial banks create money

Commercial banks create money by making loans. When a bank approves a loan, it usually does not transfer existing money from another customer’s account. Instead, it credits the borrower’s bank account with a new deposit. This deposit can then be used for spending, so the money supply increases.

The process

1. A customer deposits money in a bank.
2. The bank keeps some of the deposit as reserves.
3. It lends the remaining amount to a borrower.
4. The borrower spends the loan, and the money is deposited into another bank account.
5. The banking system can then lend part of this new deposit again.

This repeated process is called the bank credit multiplier. The amount of money created depends on the proportion of deposits banks keep as reserves, along with the demand for loans and banks’ willingness to lend.

Worked example

Assume a bank receives a new deposit of $\$1,000$ and keeps $10\%$ as reserves. It can lend $\$900$. If the full $\$900$ is deposited into another bank, that bank can lend $\$810$, and the process continues.

In the simplified model, the deposit multiplier is:

$$deposit\; multiplier=\frac{1}{reserve\; ratio}=\frac{1}{0.10}=10$$

Therefore, the banking system could create total deposits of up to $\$10,000$ from the original $\$1,000$. The additional money created is $\$9,000$.

Important limitation

This is a simplified example. The maximum amount may not be created because people may hold cash, banks may choose not to lend, or borrowers may not want loans. Therefore, commercial banks create money through credit creation, but the actual increase in the money supply depends on economic conditions.

Common mistake: banks do not create unlimited physical cash. They create bank deposits when they issue loans.