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When billy goes to the bank for a loan, the bank creates a deposit for $10000 and billy gets a note to repay with interest. The bank doesn't take from jen's deposit to loan to billy.The Money Multiplier...and Other Myths about Banking - Positive MoneyMost americans have absolutely no idea.
I wonder what you guys know?
Here's the truth:
- Loans create new money, this shows up in the form of deposits.
- The federal government creates new money through deficit spending. The central bank also plays an important role.
I expect many posters to take an issue with my assertion that Loans create deposits.
Banks do not lend out deposits or multiply up central bank money.
http://www.bankofengland.co.uk/publ...lletin/2014/qb14q1prereleasemoneycreation.pdf
This article explains how the majority of money in the modern economy is created by commercial banks making loans. • Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits. • The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’.
I expect many posters to take an issue with my assertion that Loans create deposits.
Yes, loans create deposits.
Banks do not lend out deposits or multiply up central bank money.
But of course they do.
The money multiplier model of banking has several implications:
Unfortunately, the money multiplier model of banking is completely wrong. Professor Charles Goodhart of the London School of Economics and an advisor to the Bank of England for over 30 years described this model (in 1984) as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.” Why is this?
- Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending.
- Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio or the amount of ‘base money’ – cash – at the bottom of the pyramid.
For example, if the Bank of England sets a legal reserve ratio and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy.
Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.- Thirdly, it implies the money supply can never get out of control, unless the central bank wants it to.
Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:
This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is flawed and uninformative in terms of analyzing the dynamics of bank lending. Under a fiat money standard and liberalized financial system, there is no exogenous constraint on the supply of credit except through regulatory capital requirements. An adequately capitalized banking system can always fulfill the demand for loans if it wishes to.
Piti Distayat and Claudio Bori, Bank for International Settlements (2009)
Nor do banks need reserves in order to make loans. As Alan Holmes, who was senior Vice President of the Federal Reserve Bank of New York at the time remarked:
In the real world, banks extend credit, creating deposits in the process , and look for the reserves later.
Alan Holmes, then Senior Vice President, Federal Reserve Bank of New York (1969)
The vice president of the ECB had something similar to say:
It is argued by some that financial institutions would be free to instantly transform their loans from the central bank into credit to the non-financial sector. This fits into the old theoretical view about the credit multiplier according to which the sequence of money creation goes from the primary liquidity created by central banks to total money supply created by banks via their credit decisions. In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.
Vitor Constancio, vice president of the ECB (2011)
Of course, this is just two men’s opinion, albeit men who should know what they are talking about. Thankfully empirical work has been carried out on this subject by Nobel prize winners Finn Kydland and Ed Prescott of the Federal Reserve bank of Minneapolis, who find that:
There is no evidence that either the monetary base or M1 leads the [credit] cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit] cycle slightly.
Nobel prize winners Finn Kydland and Ed Prescott , Federal Reserve bank of Minneapolis (1990)
What they are saying here confirms Alan Holmes quote above. Central bankers not only reject the money multiplier story due to their understanding of how banks operate, but also because of the empirical evidence.
There are also other reasons why the money multiplier is not a good model of how banks actually operate. For example, there’s no reserve ratio in the UK anymore, and there hasn’t been for a long time. While reserve ratios might be useful for other reasons, it is almost impossible for the central bank to use reserve ratios (or limit reserves held by banks in other ways) to restrict credit creation by banks. There are several reasons for this, not least because “banks extend credit, creating deposits in the process, and look for the reserves later”.
Of course, the central bank could choose not to provide a bank with extra reserves when requested. However, if the bank in question had extended credit and requested reserves in order to make a payment on behalf of a borrower, by not providing the reserves the central bank could create a problem for the bank in question.
For example, in a banking system with a reserve ratio the denial of reserves to a bank (which causes their reserves to fall below the regulated amount) will result in one of three outcomes:
Therefore if the Central bank wants to restrict private bank money creation supply by using reserve ratios or by restricting the amount of reserves availability to private banks, it must be willing to either allow large fluctuations in the interest rate or alternatively intermittent liquidity crises. Due to the potential for liquidity crises to turn into solvency crises, and because a solvency issue at one bank can cause a cascade of bankruptcies throughout the entire banking system, the central bank are unlikely to pursue the second option. Indeed, it goes against one of the central bank’s core functions – its mandate to protect financial stability.
- The bank may attempt to borrow the reserves from another bank. However this is likely to place upward pressure on the interest rate at which banks lend reserves to each other on the interbank market. If the central bank wishes to maintain this rate then in all likelihood it will have to provide further reserves to the banking system – undermining its efforts to restrain lending through restricting reserves.
- The central bank may allow the bank to break the rules, and operate with a reserve ratio of less than the required amount.
- The central bank may deny the bank the ability to make payments until its reserve ratio increases up to the required amount. If the bank is also unable to borrow the reserves either from the central bank or other banks this could create a liquidity crisis, as the bank in question will not be able to make the payment. This could then potentially lead to a solvency crisis and/or a financial crisis.
NEXT: Part 8 - How banks become insolvent
Firstly, the underlying concept of the money multiplier is that in order to make loans banks first require people to deposit money. However, this is simply not true. In actual fact when banks lend they create deposits:
The banks don't need the deposits before they loan, but they need the deposits in order to clear the loan check.
The fact that your loan "creates a deposit" means fuck all when the check bounces.
