Money and banks (part 8)

How commercial banks "create money"

Commercial banks obviously cannot influence the amount of currency in the economy or the monetary base, since they are not allowed to print money. They can, however, influence the money supply through the second component of the money supply - the deposits. A bank will increase the money supply simply by lending money to a customer. In the same way, when a loan is repaid or amortized, the money supply decreases.

It may sound odd that the money supply increases by 1 million the same instant a bank agrees to lend this amount. The bank has created money but no wealth (keep in mind that these are different concepts). The bank has simply converted one asset (cash) into another (the promise of repayment), while there is no change in the individual’s net wealth. However, after the loan, there is an additional one million available for immediate consumption. It makes no difference if the borrower keeps the money in her account or withdraws them in the form of currency.

If, for example, the borrower uses the money to buy an apartment, the fluids are transferred to the seller of the apartment. Tins will not affect the money supply - now it is the seller of the apartment that has a million available for consumption. If the seller uses the funds to repay the loan he got when he bought the apartment, the money supply will again decrease.

How much money can banks create?

Does tins mean that banks can create an unlimited amount of money? The answer is no - that would require them to lend an unlimited amount of money and that is not possible.

Banks use deposits to create new loans but there is an important difference between deposits and loans. When individuals deposit money in a bank, they can withdraw the money whenever they like. A bank, on the other hand, has no right to cancel a loan and get then money back whenever they like. Banks therefore need reserves so that they can deal with large withdrawals. A bank with small reserves will therefore be less inclined to lend money.

That`s all folks! I`m proud to be ending this story and hoping you`ve got some good and useful iformation about money and banks.