Monetisation at work

The process by which banks create money is so simple that the mind is repelled…

When a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower.

John Kenneth Galbraith
Former Professor of Economics
Harvard University

Below is a simplified explanation of how money is created in our current monetary system.

Depositing cash

Let's assume that there is a new bank, and on their first day Mike makes a deposit of $500. At this point the total "deposits" in the bank are $500. The balance sheet of the bank is as follows:

Balance sheet 1

Obtaining a loan

Bill decides that he wants a loan of $1,000 to purchase a new PC, and applies for "credit" from the bank. After having completed the application form, the bank approves his loan and opens his cheque account with the $1,000 available for withdrawal.

Balance sheet 2

Transaction A is a straight forward transaction. However, transaction B is where things get interesting - since this is where "money is created". By looking at this book entry it now becomes rather obvious that:

  • There is a new deposit of $1,000 (a liability to the bank)
  • There is a new loan of $1,000 (an asset to the bank).

When Mike deposited his $500 - that was the total amount of "money" in the bank. After Bill got his loan, the bank now has a total of $1,500. This logic is totally consistent with everything we have presented.

 

Using the mechanism of monetising debt (i.e. by providing credit, which when spent - turns into money) the banks increase the money supply. This is called monetary inflation, and it happens on each and every business day when the banks provide credit.

Monetary inflation is the biggest cause of price inflation.

 

Detailed accounting entries

how-banks-create-moneyPositive Money provide a more detailed explanation on their web site, and have also published a small booklet on how money is actually created.

For serious scholars on this subject, click the image on the right and you can download and read the booklet.

 

 

 

The actual process of money creation takes place in commercial banks. As noted earlier, demand liabilities of commercial banks are money.

Federal Reserve Bank of Chicago
Modern Money Mechanics
Page 3

Attachments:
Download this file (How-Banks-Create-Money.pdf)How Banks Create Money708 kB