How Is Money REALLY Created? Banks Do NOT Lend Reserves
The Fractional Reserve Banking (FRB) model is very deeply ingrained in today’s mainstream economic thinking.
This model is taught in introductory macroeconomic classes across the globe, and has been for years. Which means that every graduate, regardless of their degree, has at least heard about this if they took intro econ classes.
That’s a lot of graduates.
Now, you may be asking: Isn’t it good that many people are familiar with Fractional Reserve Banking? Isn’t it better for society if more people are familiar with how economic policy makers think?
Well the answer to the second question is yes.
The answer to the first question however, is a resounding no.
As it turns out, Fractional Reserve Banking is not what actually happens in the real economy, because banks do not lend Reserves.
This is very important and bears repeating; banks do not create new money through the process of Fractional Reserve Banking, at all.
This, of course, begs the question: How then is money created in the banking system and economy?
The answer is … ex nihilo. Which is Latin for “from nothing”. Here’s the accounting:
Like in Fractional Reserve Banking, lending is the mechanism through which money is created; unlike Fractional Reserve Banking, Reserves are not loaned out.
In fact Reserves are not present anywhere in the accounting for new loans. This is important because for Fractional Reserve Banking to work, banks must loan out Reserves, which means that Reserves should appear somewhere in the accounting.
But they do not.
Instead, when a new loan is made, the bank creates a new asset for the loan, since they will be earning interest on it. They balance this by increasing the deposit balance of the client who took out the loan.
From the client’s perspective, their deposits increase by the amount of the loan, and their liabilities increase by the same amount, since they now owe the bank the amount of the loan.
As can be seen, Reserves are not part of the process at all. Instead, when a new loan is originated by a bank, money is created through making the appropriate balance sheet entries – from nothing.
At this point, it would be completely understandable if you think that everything written above is incorrect, or some sort of misguided attempt at creating fake news. So don’t take our word for it; here’s the Bank of England explaining it in a research paper.
Of course, this new understanding of how money is actually created raises a lot of questions. What use do Reserves have since they aren’t lent out? Doesn’t this invalidate QE? What does this mean for modern monetary policy?
If you feel like your head is spinning, remember that not knowing is a good thing.
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