How banks create credit - MoneyWeek Investment Tutorials

Summary

This video offers a beginner's guide to credit creation and fractional reserve banking, explaining how banks can generate credit from a small deposit base using a retention ratio. It illustrates the concept with a hypothetical island scenario, where a bank lends out most of a deposited sum while retaining a fraction for liquidity. The script also touches on the importance of confidence in banking systems and the role of central banks in influencing the money supply through mechanisms like the discount rate, reserve requirements, and open market operations, all of which can impact inflation and interest rates.

Takeaways

• 🏦 The script discusses the concept of credit creation and how banks generate credit through the process of fractional reserve banking.
• 📚 Credit creation is a complex topic that can be the subject of an entire degree course, involving various economic principles and terminologies.
• 💡 The script uses a hypothetical island scenario to illustrate the basics of how banks create credit and the role of the money multiplier.
• 💰 The process begins with a deposit, which the bank partially retains and partially lends out, creating an IOU that can be used for transactions.
• 🔄 The bank repeats this process with the loan repayments, retaining a percentage and lending out the rest, effectively multiplying the original deposit.
• 📉 The bank's retention ratio determines how much credit can be created from the original deposit; a lower ratio allows for more credit creation.
• 📈 The formula for calculating the total credit creation is the original deposit amount divided by the retention ratio (1 / R).
• 🤔 The fractional reserve banking system relies heavily on confidence; a bank run, where everyone demands their money back at once, could cause problems.
• 🌐 Different definitions of money supply exist, ranging from M0 (narrowest definition) to M4 (broadest definition), reflecting the concept of potential spending power.
• 🏛 Central banks play a crucial role in influencing the money supply and, by extension, inflation, by setting policies that affect banks' operations.
• 🛠️ Central banks use tools such as the discount rate, reserve requirement, and open market operations to manage the economy's money supply and interest rates.

Q & A

What is the main topic of the video script?

The main topic of the video script is the concept of credit creation by banks and how it relates to fractional reserve banking and the money multiplier effect.

What is the purpose of the hypothetical island scenario in the script?

The hypothetical island scenario serves as an illustrative example to simplify the complex concept of how banks create credit and the role of the money multiplier in the banking system.

What is the role of the bank in the island scenario?

In the island scenario, the bank's role is to accept deposits, hold a fraction of those deposits as reserves, and lend out the remaining amount to customers, thereby creating credit.

What is the term used to describe the percentage of deposits that a bank keeps on reserve?

The term used to describe the percentage of deposits that a bank keeps on reserve is the 'retention rate' or 'reserve ratio'.

How does the bank create credit in the island scenario?

The bank creates credit by lending out a portion of the deposited money to customers, which they can then use for transactions, effectively multiplying the original deposit into more money in circulation.

What is the money multiplier effect?

The money multiplier effect is the process by which a bank can create more money (credit) from a given amount of deposits, based on the reserve ratio it maintains.

What is the formula that economists use to calculate the total credit creation potential from a deposit?

The formula used by economists to calculate the total credit creation potential is 1 divided by the reserve ratio (R), multiplied by the initial deposit amount.

What is the significance of confidence in the fractional reserve banking system?

Confidence is crucial in the fractional reserve banking system because it relies on the assumption that not all depositors will withdraw their money at once, which would otherwise cause a bank run and potentially lead to bankruptcy.

What are the different definitions of money supply mentioned in the script?

The script mentions that there are different definitions of money supply, ranging from M0 (narrowest definition, including only physical currency) to M4 (broadest definition, including various types of near money and potential purchasing power).

What are the three main tools a central bank can use to influence the money supply?

The three main tools a central bank can use to influence the money supply are the discount rate, the reserve requirement (or reserve ratio), and open market operations (buying and selling government bonds).

How do open market operations affect the money supply and interest rates?

Open market operations affect the money supply by either increasing or decreasing the amount of money in the banking system. When a central bank sells bonds, it withdraws money from the system, potentially raising interest rates. Conversely, when it buys bonds, it injects money into the system, which can lower interest rates.