Home | Finance | Investing

How Banks Create Money Out Of Thin Air

Banks manufacture money. They exist to make money. Bankers know how to create money out of thin air. It's true that banks provide essential financial services, such as bank accounts and loans. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money, using customer deposits.

At this point, the choice of vocabulary is critical. Banks are not just "earning" money. Banks are actually "creating" new money.

Imagine that you deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your $100,000 to create loans.

The Federal Reserve requires banks to keep a portion of their customer deposits on reserve. In other words, the bank cannot loan against the full $100,000 of your deposits. The reserve rate varies between 3-10%. With a 3% reserve rate, the bank is required to keep $3000 on reserve, and can loan the remaining $97,000. With a 10% reserve rate, the bank must keep $10,000 on reserve, and can loan the remaining $90,000. Let's assume that your bank has a 10% reserve rate, which means it can use $90,000 of your deposit to make loans.

So, the bank makes Loan #1 of $90,000 and keeps $10,000 on reserve. This is the critical point where the bank creates money. According to the bank's balance sheet, the $90,000 loan to the borrower is also a $90,000 asset for the bank. By its own brand of money magic, the bank has created $90,000 out of thin air.

It gets even more interesting. The bank does not have to stop with one loan. Since it now has an asset of $90,000, it can make another loan. Again, it must follow the Federal Reserve rules and keep 10% on reserve. This means that bank can make another loan, which is 90% of $90,000. The second loan is $81,000. And once again, the bank has created a new asset. It has created $81,000 in new money.

And since the bank now has an additional $81,000 asset, it can make another loan. Once again, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $81,000 asset. Loan #3 is $72,900.

We'll stop here, with three loans, and add up how much money the bank created. In fact, banks don't have to stop at three. Banks can repeat this process five to six times, according to Federal Reserve rules. Each new loan becomes an additional asset for the bank.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

The process is not as linear as my example. Banks don't make a series of separate loans based on an original deposit. When you deposit your money into the bank, your money becomes part of a large pool of money, which the bank can use to make loans. But my oversimplified example shows how banks use customer deposits to make money out of thin air. You deposit money, the bank keeps some on reserve, and uses the rest to make loans. The loans become assets, and the assets become new money.

Since you and I cannot do what banks do, what is the point of knowing how banks create money with customer deposits? The advantage is to take the mystery out of money.

The process a bank uses to create money demonstrates that money is not a commodity in limited supply, where there is only so much to go around. Money is not equivalent to currency. Money is created in money-making transactions, which means there is no potential limit to money.

The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited. If you want more money, adopt the money-making mindset of a banker. Ask how you can use money to create more money. If you really think the way bankers think, you will use someone else's money to create more money.

Article Source: http://www.uberarticles.com/articles

Kalinda Rose Stevenson, Ph.D. Learn the difference between earning money and making money in a real estate investing book, "No Money Limits." Visit www.NoMoneyLimits.com for your Free "52 Heart of Money Insights."

This article is licensed under a Creative Commons Attribution-No Derivative Works 3.0 Unported License, which means you may freely reprint it, in its entiretly, provided you include the author's resource box along with LIVE VISIBLE links (without "nofollow" tags).