How Money Works 2/5: “The Proof That Banks Create Money”.

More than 97% of all the money in the economy exists as bank deposits – and banks create these deposits simply by making loans. Every time someone takes out a loan, new money is created. The Bank of England recently released a report explaining how this process works:

 

Where does money come from?  In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. This description of how money is created differs from the story found in some economics textbooks.”(Bank of England)

 

See our video section for more presentations and animations about how money is created, and the impact this has on society and the economy.

What the Bank of England says about Money Creation:

What Is Money?

Bank of England, Money Creation in the Modern EconomyIn the words of the Bank of England:

“Economic commentators and academics often pay close attention to the amount of ‘broad money’ circulating in the economy. This can be thought of as the money that consumers have available for transactions, and comprises: currency (banknotes and coin) — an IOU from the central bank, mostly to consumers in the economy; and bank deposits — an IOU from commercial banks to consumers.

“Currency [bank notes and coins] only accounts for a very small amount of the money held by people and firms in the economy. The rest consists of deposits with banks.

“97% of the money held by the public is in the form of deposits with banks, rather than currency.” (Bank of England – Money in the modern economy: an introduction)

So most of the money in our economy is made up of bank deposits – the numbers that you see when you check your balance. And bank deposits are a IOU – a promise to pay, or in accounting terms, a liability – from the bank to you. But it would be wrong to think of these deposits as simply a representation of the cash that the bank owes you; in fact, these deposits function as money:

“In the modern economy, bank deposits are often the default type of money. Most people now receive payment of their salary in bank deposits rather than currency. And rather than swapping those deposits back into currency, many consumers use them as a store of value and, increasingly, as the medium of exchange.

“For example, when a consumer pays a shop by debit card, the banking sector reduces the amount it owes to that consumer — the consumer’s deposits are reduced — while increasing the amount it owes to the shop — the shop’s deposits are increased. The consumer has used the deposits directly as the medium of exchange without having to convert them into currency [notes and coins].” (Bank of England: Money in the modern economy: an introduction)

How is Money Created?

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

“Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.(1)” ­[our addition in brackets] (Bank of England, Money Creation in the Modern Economy)

In short, money exists as bank deposits – IOUs of commercial banks – and is created through some simple accounting whenever a bank makes a loan.

Learn more about how money is created by banks with our Banking 101 Video Course

Banks aren’t Middlemen between Savers and Borrowers:

There is a common idea – even taught in many economics textbooks and academic papers – that banks are simply middlemen (‘intermediaries’) between savers and borrowers. But this is inaccurate. As the Bank of England describes:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)” (Bank of England, Money Creation in the Modern Economy)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s