How Commercial Banks Really Create Money (the Money Multiplier is a MYTH).

Summary

This video explains why the popular money multiplier theory is a myth and how banks actually create money. Contrary to the traditional view, banks don’t simply lend out deposits repeatedly. Instead, they create money by issuing loans, simultaneously creating a liability for themselves and an asset for the borrower. Central banks play a role by providing reserves as needed, but money creation is not limited by reserve requirements. However, banks are still constrained by factors such as public demand for loans, capital requirements, and liquidity ratios. The video promises further exploration of central banking control in upcoming episodes.

Takeaways

• 💡 The money multiplier theory, commonly taught in textbooks and YouTube videos, is a myth.
• 🏦 Banks create money not by repeatedly lending out reserves but by issuing loans, creating simultaneous debt for the bank and the borrower.
• 📉 The traditional story of fractional reserve banking, where banks lend out a fraction of deposits, does not reflect the modern reality of money creation.
• 📝 Researchers and central bankers no longer use the money multiplier theory; modern economic studies contradict it.
• 💰 Banks create money when they lend to customers, and the bank's debt to the customer can be used as money.
• 🧩 Reserve requirements are not a real limit on bank money creation since central banks can create reserves on demand for healthy banks.
• 🌍 In countries like Canada, the UK, and Australia, reserve requirements are 0%, so they do not limit money creation.
• 📊 The true constraints on bank money creation are the public's demand for loans, capital requirements, and liquidity ratios.
• 🔄 Central bank money is still important for converting bank money into cash, but it is not necessary to initiate loans.
• 📅 The video promises a future discussion on how central banks can control money creation despite the absence of reserve requirement constraints.

Q & A

What is the main argument against the money multiplier theory?

The main argument against the money multiplier theory is that it inaccurately describes how banks create money. Researchers and economists have shown that banks do not rely on fractional reserve banking to create money. Instead, banks create money when they issue loans, recording the debt as both an asset (what the customer owes the bank) and a liability (what the bank owes the customer).

What is fractional reserve banking, and why is it criticized in the script?

Fractional reserve banking is the concept where banks keep only a fraction of their deposits in reserve and lend out the rest. The script criticizes this theory, stating that it is a myth because money creation does not rely on reserves, as central banks can create reserves on demand for healthy banks.

How do banks actually create money according to the script?

Banks create money by issuing loans. When a loan is approved, the bank simultaneously records the loan as a debt the customer owes and a liability that the bank owes to the customer, which the customer can use as money. This new debt is considered newly created money.

Why is the money multiplier theory still taught, according to the script?

The money multiplier theory is still taught because textbooks and educational materials often lag behind recent economic research. Despite the advancements in understanding how banks create money, outdated theories like the money multiplier continue to be featured in popular educational resources and videos.

What are the two main differences between the money multiplier theory and the actual process of money creation?

The two main differences are the order of events and the constraints on money creation. In the actual process, loans create money directly, without requiring central bank cash to start. The second difference is that money creation is not limited by reserve requirements, as central banks can create reserves on demand for banks.

Do reserve requirements limit banks' ability to create money?

No, reserve requirements do not limit banks' ability to create money. Many central banks, including those in Canada, the UK, and Australia, have no reserve requirement. Furthermore, central banks can create reserves for banks on demand if they are considered healthy.

What are the three main constraints on bank money creation?

The three main constraints on bank money creation are the public’s demand for loans, capital requirements (banks need a certain amount of their own capital to back loans), and liquidity requirements (banks must hold a portion of their assets in liquid form to meet potential withdrawals).

Why can't banks create unlimited amounts of money?

Banks cannot create unlimited money because they are constrained by customers' demand for loans, capital requirements, liquidity ratios, and the risk of bank runs. These factors ensure that banks cannot expand too quickly without consequences, such as losing investor confidence or facing liquidity issues.

What role does the central bank play in the process of money creation?

The central bank facilitates money creation by providing reserves to banks if they made prudent loans and need liquidity. However, the central bank does not initiate money creation. Instead, it supports the process by ensuring that banks have enough reserves to meet withdrawals or other obligations.

How do capital and liquidity ratios affect banks' ability to lend?

Capital and liquidity ratios require banks to hold a certain percentage of their assets as either capital or liquid assets like cash. This limits their ability to lend excessively. While these are not hard limits, they prevent banks from expanding too quickly, as doing so could lead to financial instability or even bank runs.