How and Why Banks Create Money When They Make Loans

All modern banks create money … one form or another. Exactly how does this occur?

First, we must remind ourselves what money is. Money is simply a medium … exchange— an object that is readily accepted … sellers in payment … the goods and services they offer. In most industrialized economies checks are still the principal means of paying … goods and services. In the United States, for example, checks account … more than four-fifths of the dollar value … all payments made annually … the economy.

When and how do banks create checkbook forms of money? It happens … two ways. First, when a customer is granted a loan, he or she will sign a promissory note and receive, … turn, a bank's demand deposit (checking account). The customer's promissory note is not money—it cannot be used to buy goods and services. But a bank's demand deposit is money and can readily be spent almost anywhere. Thus, … granting loans, banks create money simply … creating a spendable deposit … the name of the borrower.

Second, the entire system of banks also creates money as the deposits generated … lending flow … bank … bank. … law, each bank must set aside only a fractional reserve … each deposit received. Thus, every deposit received by a bank generates additional funds … and … the small required reserve that can be loaned …. As customers spend their loan money these funds flow … to other banks, giving them deposits to loan as well. Ultimately, a multiple amount of deposit money comes … existence … bank lending.

… each dollar loaned … a bank in the financial system, multiple deposits and multiple loans will be created eventually. The banking system's capacity to create money is one reason banks are regulated.

Ex. 6. Open the brackets.