How Banks Create Money

by : Tanner Larsson

Currently when banks receive a sum of money, they are able to lend out ten times that amount. That’s right for every $1 that comes into the bank, they can lend out $10.This is called the money multiplier and it is based on the required reserve ratio.

The required reserve ratio is the percentage of the total deposits the bank recieves that must be held in reserve and cannot be lent out. The required reserve ratio is determined by the Federal Reserve Bank (FRB). Whatever is left over after the reserve has been met can be lent out.

To figure out the current money multiplier, use the following formula:

1 / Required Reserve Ratio = Money Multiplier

Below you will find a basic example of how banks create money, in this example the Federal Reserve Requirement is 10%. That means that the money multiplier is 10, so the banks can lend out $10 for every dollar they receive.

---- Begin Example ----

John deposits $10,000 into his checking account at Bank A.

Bank A
Deposit: $10,000
Reserve (10%): $1,000
Lendable Amount: $9,000

Mary borrows $9,000 from Bank A and buys a car. The car dealer then deposits $9,000 into their account at Bank B.

Bank B
Deposit: $9,000
Reserve (10%): $900
Lendable Amount: $8,100

Mark borrows $8,100 from Bank B and has surgery. The doctor then deposits $8,100 into his account at Bank C.

Bank C
Deposit: $8,100
Reserve (10%): $810
Lendable Amount: $7,290

Sue borrows $7,290 and shops at Versace. Versace then deposits $7,290 into their account at Bank D.

Bank D
Deposit: $7,290
Reserve (10%): $729
Lendable Amount: $6,561

Kim borrows $6,561 from Bank D and pays off her credit card, the Credit Card Company then deposits $6,561 into their account at Bank E.

Bank E
Deposit: $6,561
Reserve (10%): $656.10
Lendable Amount: $5,904.90

And so on through the system. When M1* is measured, and the FRB totals the checking account balances in the entire system, the original $10,000 deposit will have created a total of $100,000 in deposits system wide.

*M1 = First level of money supply = All currency held by the public.

---- End Example ----

That in its simplest form is how the banks create money. Now considering how much money the banks are making off of every dollar you deposit, does the 0.01% or 0.25% interest rate you’re getting paid seem fair?

Not to me, but because the general public is uninformed of this fact of life, the banks and other financial institutions will continue to reap extraordinary profits from practically imaginary money.