How is money really made by banks? - Banking 101 (Part 3 of 6)

Summary

This video script explains how money is created in the modern economy, debunking the traditional model of money supply. It explores three types of money—cash, central bank reserves, and bank deposits—and how banks create money by simply typing numbers into customers' accounts when they issue loans. The process of inter-bank settlement is also covered, showing how banks use central bank reserves to settle transactions. The video argues that the real power over money creation lies with the banks, whose confidence and lending practices drive the money supply, rather than being strictly controlled by central banks.

Takeaways

• 😀 Banks create money by lending, not by simply exchanging existing funds.
• 😀 The money supply is not limited to a physical base of cash but is influenced by bank lending and borrowing.
• 😀 The traditional model of money creation (a pyramid structure) is inaccurate; it's better to think of it as two balloons expanding.
• 😀 When a bank issues a loan, it credits the borrower's account with digital money, creating a new liability for the bank.
• 😀 Payment systems like BACS and Visa debit net out transactions, reducing the amount of central bank reserves needed for settlement.
• 😀 Banks create money by typing numbers into customers' accounts when loans are issued, essentially creating digital money.
• 😀 Central bank reserves are used for settlement between banks, but only the net difference is actually exchanged at the end of the day.
• 😀 The amount of money banks create depends on their confidence to lend, rather than a fixed limit.
• 😀 Fractional reserve banking allows banks to keep only a fraction of their deposits in reserve, creating more money through loans.
• 😀 The banking system relies on trust; if confidence wanes, the system may collapse (e.g., in the event of a bank run).
• 😀 There's no natural limit to the money supply; it can grow or shrink based on economic conditions and banking behavior.

Q & A

What are the three types of money discussed in the video?

The three types of money in the economy are: 1) Physical cash (coins and banknotes), 2) Central bank reserves (electronic versions of money created by the central bank), and 3) Bank deposits (electronic money created by commercial banks when they make loans).

How do commercial banks create money?

Commercial banks create money by issuing loans. When a customer takes out a loan, the bank credits the customer's account with the loan amount, effectively creating new money in the form of bank deposits.

Why is the traditional textbook model of money creation inaccurate?

The traditional model suggests that the money supply is determined by central bank money, with commercial banks only able to lend out a fraction of this base money. However, the video argues that banks can create money with no natural limit, meaning they are not constrained by a fixed base of central bank money.

What is the role of the central bank in the money creation process?

The central bank creates central bank reserves, which are used by commercial banks for settling payments between each other. However, the central bank has less direct control over the actual creation of money, which is largely driven by commercial bank lending.

What is the difference between the pyramid model and the balloon model of money creation?

The pyramid model suggests a fixed relationship between central bank money and commercial bank money, with the central bank providing a base for money creation. The balloon model, on the other hand, shows that central bank money is just one part of a larger system where commercial banks can create money independently, like two balloons inflating simultaneously, without a strict limit.

How do inter-bank payments and settlements work in the banking system?

When one bank owes another bank money due to customer transactions, the payment is settled using central bank reserves. The payment systems like BACS or Visa net out payments between banks so that only the net balance is transferred at the end of the day.

What does 'fractional reserve banking' mean, and how does it work?

Fractional reserve banking refers to the practice where banks only keep a fraction of the total amount they owe customers in reserve, rather than holding 100% of deposits. The rest can be lent out, creating more money in the economy.

Why don't banks need to keep large reserves at all times?

Banks don’t need to keep large reserves because payment systems net out the money owed between banks, meaning that only the net difference needs to be settled. This significantly reduces the amount of reserve money banks need to maintain.

What determines the size of the money supply in an economy?

The size of the money supply is primarily determined by the lending behavior of commercial banks. The confidence banks have in lending and the demand for loans directly influence how much money is created, not by central bank regulations or reserve requirements.

How do the central bank and commercial banks interact in the settlement process?

When a customer of one bank makes a payment to a customer of another bank, the transaction is processed through a central bank's reserve system. The banks involved in the transaction will settle the payment using central bank reserves, and the payment systems (like BACS or Visa) handle the netting of payments to reduce the need for large transactions.