The economics of deposits, loans, and the money multiplier

You may have heard a variation of this story before:

Alice, an author, deposits a $100 check she received as an advance for her next book in the bank. Brandon Baker takes that $100 out as a loan from the bank to buy flour for his bakery from Mary Miller. Mary takes the money, and pays Frank Farmer for what she owes him for the wheat. Frank then takes the hundred dollars, and pays Mike the mechanic for what he owes him for repairing his tractor. Then Mike takes the money, and pays $100 he owes Brandon for catering for Mike’s wife’s birthday party the week before. Brandon takes the hundred dollars to the bank and settles his loan. Finally, Alice decides she wants to have the cash in hand after all. So, she withdraws her hundred dollars, which she receives in the form of the bill Brandon just used to pay off his debt. She promptly puts it under her mattress.

In the end, the bank and Alice’s balances are exactly as in the beginning, but everyone else’s debts, 400 dollars’ worth of economic activity, are settled thanks to Alice’s $100 initial deposit which she withdrew shortly after.

Usually, this anecdote is told with the implication that there is something rather suspect with banks.

Fast money

If you ever said, or heard someone say, that there is money burning a hole in your pocket, you can relate to concept of the velocity of money. As you probably gathered from the story above, the more times the same money gets spent within an economy, the higher its velocity.

For the mathematically inclined. Otherwise, safe to skip:

V = (P x Q) / M

Where:

V = Velocity
P = Price level
Q = Real economic output, so P x Q = Nominal GDP
M = Money in circulation

The velocity of money depends on several factors:

• Interest rates: The higher they are, the more people want to save, or not spend, so velocity goes down.
• Inflation: The faster money loses value, the faster people want to spend it.
• Trust in the economy: The more confidence they have in the economy, the more people and businesses are willing to part with their money. We will come back to this later.
  

Printing money

We all know that in most economies, central banks, such as the US Federal Reserve, the Royal Bank of England, or the People’s Bank of China, have the exclusive right to issue currency in a country, or union, as in the case of the European Central Bank.

But commercial banks can also create money on their own. They do so through the money multiplier effect. A concept that is separate, but closely related, to the velocity of money, and one of those things that economists just love to argue about.

Reimagine our example above, but instead of people owing money to each other, the money gets deposited and borrowed through the bank. Congratulations, you just discovered the money multiplier. The Fed (or central bank) printed the $100 bill, but the bank created another $400 on top of it by taking deposits and giving out loans.

Now, central banks are jealous custodians of their exclusive ability to issue money, so they usually control commercial banks’ ability to create money by imposing a minimum reserve requirement ratio.

Take a reserve requirement ratio of 10% for the little neighborhood in our example. If Alice makes a $100 deposit, the bank can only lend $90 to Brandon, who pays it to Mary, who deposits the $90, of which $81 can be loaned to Frank, who pays it to Mike, who deposits the $81.

Now, we have total deposits worth 100 + 90 + 81 = $271 originated from Alice’s initial $100, thanks to the money multiplier effect resulting from the bank having made $171 in loans. That is $171 of real money that Brandon and Frank owe the bank, and the bank in turn owes Mary and Mike.

Central banks control how much money banks can create and put into the economy by tweaking the reserve requirement. The higher the requirement, the lower multiplier effect because the more money banks have to keep in reserve, the less they have left for loans.

Another one for the math-inclined:

The money multiplier is the inverse of the reserve requirement.

m = 1 / RR

Where:

m  = Money multiplier
RR = Reserve ratio

Note: This is a theoretical upper limit of the multiplier. Most banks are conservative, and hold more reserves (excess reserves) than required. So in reality, the multiplier is significantly lower.

And, that is how commercial banks create money.

In God we trust

Most countries have established money by fiat. Fiat money is not backed by any tangible commodity, other than the trust that people have in the economy, its institutions, and the say so of government that issues the money.

If money is built on trust, then this trust is important. Banks exist because within the larger economy, the Alices, Brandons, Franks, and Mikes of the world do not know each other. As there are no relationships among them on which to build trust in a short time. So, the bank steps in to provide that trust, and business can happen.

It is this trust that allows commercial banks to create the money on top of the central bank’s original issue, adding to the supply of money in an economy.

When this trust disappears, we feel the pain in multiple ways: People with money are fearful and unwilling to spend or loan it. And those who need it to consume or to invest are unable to get a loan. When the velocity of money plummets, the result is a credit or liquidity crunch, and there isn’t enough money to keep the economy moving.

Bankers’ trust

People intuitively understand that commercial banks have the ability to create money. Very often, this understanding is incomplete, and it can lead us to believe that banks are creating the money out of nothing, which would be very suspicious indeed. Incomplete kernels of truth like this can lead us to believe the many conspiracy theories that prompted the writing of this article.

If this text did its job, the reader will now have an understanding that:

• There is a system
• It is well understood
• It is working as intended
• There’s generally nothing particularly nefarious going on in banks
• But it also puts bankers in a privileged, and powerful position in the economy, as custodians and traders of trust.
  

This is why commercial banks are subject to some of the strictest regulations governments impose on the private sector. Businesses rely on the trust that people have in their brands to sell their goods or services. When trust on a brand goes, companies lose the ability to do business. But bankers’ product is trust itself. And when they forget it, it is not only their business that suffers, but the economy as a whole.

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Read the original text in Medium.