Update Dec 2015. This version does not reflect the way modern banks work. A new version is posted here.

[Update 18 March 2010: this is the text-book explanation, but Steve Keen argues persuasively that this is only a minor part of the modern money creation process, most of which is beyond the control of central banks. See Kevin Cox’s comment below, including his proposed remedy.]

A little-known or poorly understood fact about our banking system is that banks create money. Out of nothing.

That in itself need not be a bad thing. We need a medium of exchange, which is the basic function of money, and the money has to come from somewhere. However the creation of new money is buried within our fractional-reserve system of banking. This makes it invisible to most people. Also, banks create the money in the course of making loans, which means they can charge interest on money they create at essentially no cost to themselves. That is a guarantee of unearned profits, even apart from the myriad fees banks charge for other services.

Because the fact and the process are obscure, I post here an explanation of how it comes about.

Here is how modern banks create money.First we will look at how it would work if there were no reserve requirement at all, since it is simpler to explain.We can then look at how a fractional reserve requirement modifies the process.

If you ask your bank for a loan of $100,000, they may loan you the money provided they have $100,000 in uncommitted deposits to cover it.(This may seem like a 100% reserve requirement rather than a 0% reserve requirement, but read on.)If they give you the loan, two things are created simultaneously:a check (or checking account) for $100,000 and a debt (yours) for $100,000.So far, things seem to be in balance, since there is a credit and a balancing debit in your account.Now if you pay a builder to build a house for you, the builder can deposit your check in his bank.However, there is no label on this money to say it is borrowed.Therefore, the builder’s bank now has simply another $100,000 deposit,and it is free to make loans against that amount.Thus the money is still free to circulate.Furthermore, in a zero-reserve system,your own bank has not written to any of its original depositors saying their money is not available for them to spend because the bank has it loaned out.The original $100,000 in deposits is also still free to circulate.

There is now $200,000 in circulation, and a new debt of $100,000, a debt that you owe.The net effect is that $100,000 in new money is circulating.While this money and your debt notionally cancel each other, the dynamics induced by borrowed money are not the same as the dynamics of saved money.This is because loans can now be made against the $200,000 and the process can repeat.Thus the new money can be compounded into more new money.Accompanying this growth in loaned money are ever-increasing levels of debt, and debt is a pervasive feature of the world at present.

If these transactions were done with real, physical cash, the dynamics would be different.The original $100,000 in deposits would physically be passed to you, then to the builder, and finally to the builder’s bank and would therefore not be available to your bank’s depositors to spend.Nor would the original deposit be available to loan to someone else.Thus the amount of circulating money would not increase through the process of making a loan.The problem arises in part because most money these days is not physical money, it is simply numbers in computers, and because loan transactions are not accounted for in the same way as cash would be.The potential magnitude of the problem can be seen from the fact that in Britain in 1997 the total amount of cash (called M0) was only 3% of the total amount of money, including loans (called M4).In the U.S.,all of the money originates as loans, and some of it is converted into cash by the Federal Reserve banks[i].

Now lets include the effect of the fractional reserve requirement in the process.In the U.S., banks are required to hold between 8% and 18% reserves on the loans they issue as demand deposit (checking) accounts.Lets do an example where the requirement is for a 10% reserve.Then if the Amity Bank has $100,000 in deposits, it can only lend out $90,000 of it.Suppose it loans $90,000 to Mr. Able, who pays Mr. Builder to build him a house, and Mr. Builder deposits the $90,000 with the Business Bank.Now the business bank can lend out 90% of the $90,000, which is $81,000.If Ms. Careerwoman borrows the $81,000 to buy a luxury car, and Mr. Cardealerdeposits this in his Caring Bank, then Caring Bank can loan out 90% of $81,000, which is $72,900.And so on.The sequence is depicted in the following Figure.

The money creation sequence with a 10% fractional reserve. Each time a new loan is granted, new money is created (lowest boxes).

This sequence also seems to go on forever, just as it did with no fractional reserve, but the amount of money generated is not unlimited.Mathematicians have worked out that this sequence adds up to a finite amount of money.Lets call the reserve fractionr.So in our example,r = 0.1, which is the same as 10%.Then the fraction available to be loaned is (1-r), which we can calll.In our example,l = 0.9.If we call the original depositD ( = $100,000), then the total amount of new money (N) created isD(1 +l +ll +lll + … ), and the result of this summation isN =D/(1-l) =D/r.So, in our example the total amount of new money isN = $100,000/0.1 = $1,000,000.

In other words, if the required fractional reserve is 10%, the amount of new money that can be created from the original deposit is 10 times that deposit.If the reserve requirement is 20%, then the deposit can generate 5 times as much new money.If the reserve requirement is only 5%, then 20 times as much new money can be generated.And so on.