Is It True That Banks Can Create Money Out of Thin Air?
" "The idea that banks can create money out of thin air has sparked much debate and confusion. However, this notion can be misunderstood. Let's clarify how banks generate money, the role of central banks, and the mechanics of the money supply.
" "How Banks Create Money
" "Banks do not create money out of nothing in the sense that money can appear from nowhere. Instead, they create money by writing loan contracts. When a bank makes a loan, it records a new asset on its balance sheet - the loan contract - and credit the borrower's account with the loan amount. This new credit is considered 'new money' in the money supply, even though the physical cash or reserves used to make the loan were there before.
" "This process is not quite money creation out of thin air. The "backing" for this new money comes from the borrower's promise to repay the loan. This promise of future financial transaction is valued and reflected in the loan contract, giving the new money its value.
" "The Role of Central Banks
" "Central banks are responsible for printing physical currency and setting monetary policies. Commercial banks cannot print money; they are not allowed to create cash out of thin air. Central banks can influence the money supply directly, but it's a different mechanism from the creation of new money through lending.
" "Commercial banks generate money through lending activities. The new money created through these transactions is accounted for on the bank's balance sheet. Unlike central banks, commercial banks do not create 'reserves' for their customers to loan out; instead, they keep these reserves to cover potential customer withdrawals or bad debts.
" "Tracking the Money Supply
" "The tracking of how much money is in circulation is a complex process. The money supply, often denoted as M1, M2, and other monetary aggregates, is continuously monitored by central banks and financial institutions. Different monetary aggregates include various types of money, from physical cash to bank deposits.
" "Commercial banks and central banks collaborate to ensure that the money supply remains stable. Banks keep a certain percentage of their deposits as required reserves, and the rest is loaned out. This process does not mean that banks can create an unlimited amount of money. There are strict regulatory limits on how much banks can lend compared to their reserves and capital.
" "Lending and Economic Growth
" "When a bank lends money, it creates a new asset on its balance sheet and a corresponding liability in the form of the loan. This transaction can increase the money supply without the need for additional physical cash. For example, if you lend money to your friend with a promise to pay you back, the lending party's balance sheet includes the loan asset, while the borrower now has the equivalent in an account. This is not 'money creation out of thin air,' but rather a transfer of existing means.
" "From a macroeconomic perspective, lending creates more money indirectly through the creation of financial assets. However, the initial source of liquidity often comes from the bank's reserves or deposits from other sources. This process is akin to rerouting funds rather than creating new funds ex nihilo.
" "New money is also created when borrowers spend the loaned money, leading to transactions that generate more economic activity. These transactions can eventually lead to wealth creation and economic growth. However, excessive lending can lead to inflation if the supply of money outstrips the economic output.
" "Other Sources of Money
" "Banks also have other ways to generate cash for lending. They can sell existing loan contracts, issue new shares of stock, or solicit new deposits from customers. These methods are similar to how individuals or businesses obtain cash to make loans.
" "For example, if a borrower defaults on their loan, the value of the loan contract decreases, leading to a reduction in the money supply. If the default is significant enough, the physical cash may still be around, but its value is diminished due to the worthless loan contract.
" "Thus, while banks do not create money out of thin air, the process of creating and re-circulating money through lending and borrowing is a crucial part of financial systems. Understanding this process helps to clarify misconceptions and provides a clearer picture of how money is generated and managed in an economy.