I read somewhere that money is created through lending in America, and did some googling and chating with GPT. I still have a hard time understanding how money is created by banks through lending. Somehow when a new loan is made, an equal an opposite liability is made and the Reserve creates that additional money?
Does this mean that when I get a new line of credit, that new money is created? Can someone clarify how new money is created here?
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What you’re asking about is called *fractional reserve banking*. Here’s how it works:
Bob has a bank. 10 people each deposit 10 gold coins in his bank. In exchange, each of those people get a piece of paper that says “Bank statement…Balance…10 coins”. Which can be rephrased as “IOU 10 gold coins – Bank of Bob”.
One day Harry Homebuyer borrows 80 gold coins from the Bank of Bob and uses them to buy a house from Sally Seller. After the transaction goes through, here are the facts:
– There are 20 gold coins in the vault at the Bank of Bob.
– There are 80 gold coins in Sally’s purse.
If we say “Money = gold coins,” then there are still 100. No new gold coins were created.
But if you go around asking people how much money they have, a funny thing happens.
– When you interview Sally, she says “I have 80 gold coins. I can prove it, they’re right here in my purse.”
– When you interview the 10 depositors at the Bank of Bob, they each say “I have 10 gold coins. I can prove it, I have a statement from the Bank of Bob right here.”
Adding up how much money people think they have, you get 180 gold coins. That’s because we changed the definition to “Money = gold coins outside of bank vaults + bank deposits.”
Bob’s vault actually contains two things:
– 20 coins
– A piece of paper called a *mortgage* that says “I will pay you 2 gold coins a year for the next 30 years — Harry Homebuyer.” Which we can shorten to “IOU 200 gold coins (over 30 years) – Harry Homebuyer.”
Bob is hoping that either (a) no more than 20% of his depositors ask for their gold coins back at a time, or (b) he can get more gold coins by selling the IOU from Harry Homebuyer to another bank.
(For a variety of reasons, the US has replaced “gold coins” with “green pieces of paper printed by the government.” The government printing more green pieces of paper, or miners digging up gold out of the ground *also creates money* but is a *fundamentally different process from fractional reserve banking*.)
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