I keep hearing that when banks loan money, it creates money and increases the money supply. But this confuses me. Wouldn’t the money have to have already been created in order for them to lend it in the first place? I don’t see why lending money that already exists would “create” new money?


1 Answer 1


In a fractional reserve system, banks increase the money supply because loans are backed by demand deposits. In other words, banks will give out loans using the bank deposits of customers. The customer whose money is being lent is nonetheless still able to withdraw or transfer their bank balance, which means the money supply has expanded. For example, if a bank has 10 dollars in customer deposits, and lends out 9 dollars, 9 dollars has now been added to the money supply, because the customer retains the ability to use and spend their 10 dollars balance and the recipient of the loan now also has 9 dollars to spend.

It may seem that fractional reserve banking is self-contradicting, because evidently the bank could not honor a withdrawal request on demand by the customer for their whole 10 dollar balance after having lent out 9 dollars. This problem is somewhat reduced because in the real world, it is generally unlikely that all customers would demand all their deposits all at once, so a bank only needs to hold a certain percentage of deposits on hand to satisfy demand for withdrawals, which is the reserves of a bank. Also note that if a customer just wants to transfer money from one account to another within the banking system, that doesn't draw on bank reserves at all (and in fact, one of the early tactics banks used in times of crisis before the Federal Reserve system was to temporarily ban cash withdrawals, while allowing transfers between bank accounts).

Of course, sometimes the assumption that there will not be a sudden demand by all depositors for their money fails, which causes a bank run. Bank runs often will result in bank failure, since the bank only has part of depositors' deposits in ready money, while the rest is tied up in loans, which can't necessarily be immediately called in.

In contrast, in a full reserve system, which maybe is a more "intuitive" system of banking, banks only lend from time deposits. For example, if a bank makes a loan of 10 dollars in a full reserve system, it will make the loan from certificate of deposits or other long-term instruments, where the customer has deposited their money for a fixed period and cannot withdraw it before then. In this system, no money is created because the creation of new money by a loan is offset by the temporary "freezing" of the customer's deposit in a time deposit.


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