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I've been reading some introductory macroeconomics and I'm struggling to understand one of the basic accounting identities. In a closed economy with a fixed money supply it's clear that every dollar saved is a dollar invested. I'm happy with the standard story.

What I don't understand is how the identity works when money is created privately. I can go to a bank an ask for a million dollar business loan. The bank grants me the loan, and creates an asset (the loan) and a liability (the money in my account). I then invest the money. It seems from this example that I have created a million dollars of investment without creating any offsetting savings. Of course, I have to pay off the loan at some point, but then shouldn't the identity be something like investment = savings + debt?

What am I missing?

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  • $\begingroup$ It's a good question, but I think the macro identity S=I is much more trivial than you're thinking. You invest the $1m in a car for your fleet, but that $1m is savings to the seller. So, in this example, I think the answer is that the savings came "after" the investment. I don't think "S=I" requires any comment on causation. There are many critiques of the applicability of the loanable funds model for saving & credit creation. $\endgroup$
    – David
    Aug 17, 2022 at 4:03

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Say you take out a \$1m loan from ABC Bank - they create two entries on your books:

Assets: \$1m cash available funds.

Liablities: \$1m loan you owe the bank.

Similarly on their books they create two entries:

Assets: \$1m owing from Simon Lyons

Liabilities: \$1m payment we must honor.

Now you buy a factory with the \$1m. You write a cheque to Bob who you're buying the factory from. He banks with XYZ bank.

Your books:

Assets: A factory worth \$1m.

Liabilities: \$1m loan you owe the bank.

The bank's books:

Assets: \$1m owing from Simon Lyons

Liabilties: We owe \$1m to XYZ bank.

In practise what happens is that the banks are exchanging money between each other all day (for example XYZ bank customers may have paid cheques to ABC bank customers), and at the end of the day they need to settle the difference by taking a loan from someone.

In New Zealand's system for example, that difference can be borrowed from the Reserve Bank (New Zealand's central bank) - paying interest at the Official Cash Rate (OCR). This rate is set by the Reserve Bank - and is the primary means that the Reserve Bank controls inflation.

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    $\begingroup$ i think your example would become much clearer if the books of Bob were also included. Then it would be clear that Bob now holds savings equal to the asset value and the banks just intermediate between Bob and Simon $\endgroup$
    – HRSE
    Oct 23, 2015 at 3:13
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The bank being willing to lend you a million dollars implies that others are saving enough to finance your investment.

The bank won't lend to you unless others are saving because you will spend the money in your account. This means the bank will no longer owe you, but owe other banks instead. Other banks won't accept the loan your bank made to you as a means of payment and they'd rather not hold any deposits with their competitor so your bank needs to have an asset that is an acceptable means of payment between banks. And they would have funded the purchase of that asset through the savings of others (depositors, owners, other financial institutions).

Interbank means of payment have changed over time, currently for large banks it's generally liabilities of the country's central bank, like the Bank of Canada in Canada.

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  • $\begingroup$ This is not how modern lending works; look up money creation. $\endgroup$
    – Giskard
    Jan 6, 2022 at 12:16
  • $\begingroup$ @Giskard Say I take out a mortgage for \$500,000 from Bank A and immediately spend it on a house. Bank A will have to transfer \$500,000 to the house seller's bank, Bank B. Where does that \$500,000 come from? It comes from somebody lending Bank A money and/or from Bank A's owners. Bank B won't accept a deposit in Bank A, they'll want a different form of money. In Canada, the large banks transact with each other across the Bank of Canada's books with settlement balances. $\endgroup$
    – James Wattam
    Jan 7, 2022 at 19:23
  • $\begingroup$ @JamesWattam I think you're not taking into account that the Fed will supply as much reserves as demanded at the current FFR. They set price & let quantity float. So, that $500k could theoretically come from another depositor who turned in $500k in cash...or it could be from Bank A just borrowing it from the CB (at the discount window, for a stupid but simple example). $\endgroup$
    – David
    Aug 17, 2022 at 4:00
  • $\begingroup$ @DavisClute Banks in the US and Canada very rarely borrow from their central banks because it is costly and implies that the borrowing bank cannot find anybody to lend it money at a better rate - a very bad sign for its creditworthiness. For example; compare the advances line item on the Bank of Canada's weekly balance sheet here to the Bank's total assets. $\endgroup$
    – James Wattam
    Aug 20, 2022 at 22:40
  • $\begingroup$ @JamesWattam Reserves are supplied through OMO primarily. I even said the discount window example was stupid, but simple, for the exact reason you note. $\endgroup$
    – David
    Aug 27, 2022 at 14:34

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