posted on Aug, 4 2015 @ 08:45 PM
a reply to: Aloysius the Gaul
Let's walk through a hypothetical example to show how the act of bank lending creates new money. Say that person A has $100 dollars in cash and
decides to deposit this money into a bank. The bank has a reserve ratio of 10%, and so it must keep $10 in reserves but can loan out the other $90.
Let's say the bank makes a $90 loan to person B.
Time to stop and recap what just happened. Person A originally had $100 cash and consequently $100 worth of purchasing power. When person A deposits
this money into a bank, they still have $100 in purchasing power. The bank then loaned out the $90 that it was not required to hold as reserves and
this money went to person B. Now person B has $90 worth of purchasing power, and person A still has $100 of purchasing power. Money was just
In the micro economy of our example, $100 in original purchasing power has just turned into $190 worth of purchasing power. The amount of money in the
economy that is able to chase goods and services just increased as a result of bank lending.
Taking this forward another step, let's say person B pays this $90 to person C, who then deposits it into a bank. This could be the same bank or a
different one, it doesn't matter. The bank must keep $9 of this new deposit (remember 10% of $90 is $9) and can loan out the remaining $81. If the
bank lends out the $81, the money supply in the economy grows again. What started as $100 that was available to chase goods and services has grown
into $271 of purchasing power ($100 + $90 + $81).
This process can continue over and over as the money is redeposited into banks to be loaned again. If this process continues to its maximum, the
original $100 can grow into $1000. Notice that this relationship between the initial deposit and the maximum growth is a factor of the inverse of the
reserve ratio. A reserve ratio of 10% allows a deposit to grow into 10 times as much money. What we have just described is the "money multiplier"
model. An initial sum of money has "multiplied" through bank lending.