How banks create credit - MoneyWeek Investment Tutorials
Summary
TLDRThis 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.
Outlines
🏦 Introduction to Bank Credit Creation
This paragraph introduces the complex topic of bank credit creation, which is fundamental to understanding the economy. It simplifies the concept by explaining it through a hypothetical scenario of being stranded on an island with a bank. The script discusses the basics of how banks operate with deposits and loans, and the concept of the money multiplier, which is central to the process of credit creation. It also touches on the different definitions of money supply and the importance of the retention rate set by banks for lending purposes.
📊 The Mechanics of Fractional Reserve Banking
This paragraph delves deeper into the mechanics of fractional reserve banking, illustrating how a bank can lend out a portion of the deposits it receives while retaining a fraction for liquidity. It uses the example of a 10% retention rate to explain how the bank can theoretically create a thousand pounds from an original deposit of one hundred pounds. The paragraph also introduces the formula for calculating the potential credit creation and discusses the importance of confidence in the banking system to prevent bank runs.
🌐 Central Banks' Role in Monetary Policy
The final paragraph discusses the role of central banks in influencing the money supply and, by extension, the economy. It outlines three main tools that central banks use: the discount rate, the reserve requirement, and open market operations. The paragraph explains how these tools can affect the amount of money in circulation and, consequently, interest rates and inflation. It emphasizes the importance of the central bank's role in maintaining economic stability through careful management of the money supply.
Mindmap
Keywords
💡Credit Creation
💡Money Multiplier
💡Fractional Reserve Banking
💡Deposit Rate
💡Money Supply
💡Inflation
💡Central Bank
💡Discount Rate
💡Reserve Requirement
💡Open Market Operations
💡Interest Rates
Highlights
The video provides a beginner's guide to credit creation in banking.
Explains the concept of the money multiplier and its role in banking.
Introduces fractional reserve banking and how it works.
Uses a hypothetical island scenario to illustrate credit creation.
Describes the process of depositing money in a bank and the bank's decision to lend out a portion of it.
Explains how banks can create IOUs through lending, effectively expanding the money supply.
Details the importance of the reserve ratio in determining the amount of credit a bank can create.
Presents the formula for calculating the total credit creation based on the reserve ratio.
Discusses the reliance of the banking system on confidence and the risks of a bank run.
Differentiates between various definitions of money supply, from M0 to M4.
Explains the impact of the money supply on inflation and economic stability.
Outlines the role of central banks in influencing the money supply and economic policy.
Describes three main tools used by central banks to influence the economy: the discount rate, reserve ratio, and open market operations.
Explains how the discount rate can influence the attractiveness of financial instruments.
Discusses the effects of changing the reserve ratio on the banking system and money supply.
Details the process and impact of open market operations on the economy.
Concludes with a summary of how central banks use these tools to manage inflation and stabilize the economy.
Transcripts
[Music]
this video is going to take on a little
bit of an economics you type topic very
topical at the moment how do banks
create credit now this is one of those
topics that can take up an entire degree
course there are professors and Nobel
Prize winners out there grappling with
it so don't expect too much rocket
science from this video this is a
beginner's guide to how credit creation
works and I'll be throwing in a couple
of other bits of jargon that are
popularly associated with it what is the
money multiplier there we're going to
Taylor at the moment and how does
fractional reserve banking work okay so
all of that in a one video but
essentially it boils down to this what
is credit creation and more importantly
when people talk about the money you
supply what do they mean is it possible
to have more than one definition of the
money supply and the answer is yes it is
and I'll try and explain why that is in
just a moment now then a hypothetical
scenario allow me a bit of artistic
license here okay imagine this
is an island okay surrounded by
shark-infested water shark right another
shark all right so it's an island and
you are washed ashore on this island now
bear with me there is a point for this
all right with a hundred pounds admits
fairly unlikely scenario so far but bear
with me so as far as you know that is
you on the island and you've washed
ashore hundred pounds
all right somehow that survived the
vacuole just been in the sea right and
you're thinking right well I I need 100
pounds I don't know anything about this
island it could be full of wild animals
or cannibals running so when I wander
around and see if I can find myself
something to spend 100 pounds on and
blow you down if the first thing you
don't find on the island isn't always
the way is a bank okay so you think
right what about hundred pound just
washed up all the bring the island so
maybe what I better do is is put this
money somewhere safe for the time being
all right so you find a bank and you
think right I want to do I'll go in and
I'll put the money on deposit for the
bank all right look is until I can find
something spending on it's probably
safer in there all right so you put your
hundred pounds into the bank all right
so that there it goes now then you sort
of wander off try not to get eaten
right now the bank makes a quick
calculation okay it thinks right
if Kim comes back in in half an hour's
time how much of that hundred pounds do
I need to keep back now you might see a
hundred pounds but actually that's
unlikely when you go to the cash point
machine you don't generally drain the
entire account okay you take 50 pounds
out or ten pounds or something right so
the bank is going to be thinking I need
to hold some of this hundred pounds
ballade I don't necessarily need you to
settle more one hundred pounds just in
case
Tim happens to want some out of the cash
point machine tomorrow morning or comes
back in and asked to redraw it so maybe
what I'll do is I'll hold back on ten
pounds
okay and I'll lend out the remaining 90
now the bank has a customer who wants to
borrow money so the bank keeps ten
pounds back and lends out ninety to that
customer all right and the reason that
customer wants the money is they want to
trade all right they want to buy
something with it so if you're following
me now the 90 the 90 pounds in the form
of the IOU if you like the customer
wants to buy some goods all right and so
basically they do a trade and this
person who they've just traded with then
decides to put the 90 pounds for
safekeeping
back into the bank and the bank thinks
okay I better hold 10% of that back in
case this customer comes back looking
for money tomorrow morning so the bank
keeps nine pounds and then all ends out
81 now I'm running a have Island here
you probably get the idea with a 10%
deposit rate if you like or retention
rate the bank can keep creating io u--'s
that allow other customers to undertake
transactions or to trade okay so the
bank is estimating that it can get away
with only holding back 10% of each
deposit it doesn't need to hold the
whole lot and actually if you carried on
this process with more and more
customers I'll stop after sort of the
first three if you like you could work
out in theory how many io u--'s or how
much credit the bank could create of one
deposit of 100 pounds all right and the
answer actually on a 10% retention ratio
is in total deposit terms the bank could
create effectively a thousand pounds out
of 100 all right
if I change this to the bank keeping 20
pounds back of the original 100 pounds
all right then the bank would only be
able to create 500 pounds in total all
right
made up the deposits and credit so in
other words the rate that the bank
decides to use to determine what
proportion of say the hundred pound
deposit it's going to keep and what
proportion is going to lend out
determines in turn how much credit in
total could be created from the original
100 pound deposit all right there's a
little formula that economists use which
I want for you with too much but one
over R where R is armed the rate and so
for example if R is 10% all right then
100 pounds divided by 10% which is not
0.1 is a thousand okay if the the rate
is 20 percent 100 pounds over point two
that's 20 percent is 500 pounds and so
on so I'm being a little bit fast and
loose with my economic jargon here but
that's that's by the by the principle is
that this system allows the bank to
generate if you like credit generate
funds from a relatively small deposit
base all right then that's the essential
basis of what's called fractional
reserve banking now you might be
thinking there's a problem with this and
there is a big one it relies on
confidence it relies on the bank judging
or perhaps being told by a central bank
that 10 percent is the right ratio for
example because it does rely on people
not literally running map the bank and
demanding all their money back at once
that would cause me the problem and all
the banking system is built on that
basis I'm not expected to go running
down to Lloyds TSB this morning and
empty all my accounts in one go I mean
in theory I'm entitled to do exactly
that
the banking works on the premise that I
won't because my day-to-day existence
doesn't require me to have access in
cash terms to all the money that in
theory belongs to me
right so obviously getting that ratio
right is fairly important and what we'll
do is just wrap up by considering in
essence how central bank's influence the
supply of money in an economy because
economists will look at this island and
say how much money is on the island it
depends what you mean by money you see
some people would say well there's only
ever a hundred pounds here somewhere
isn't there you know that's what I
washed ashore with or maybe not maybe as
soon as the bank enters a transaction
with whoever this is is the money supply
could you widen the definition and say
the money supply is more like those two
adil together if you know the money
supply is sort of potential spending
power let's say so you get these
different definitions of the money
supply they call Em's m naught all the
way through to m4 and without going into
the detail economics of it they're based
on the idea that money is a slightly
fluid concept is it just notes and coins
in circulation or is there a bit more to
spending power than that okay now maybe
a final note in this video on central
banks and their role in this sort of
whole arena because there is there a
couple of questions thrown up here and I
won't attempt to answer them in detail
but one of them is you know what
determines whether that's 100 pounds or
not in the real world rather than this
des Island where I was washed up and the
out the money supply is something that
has a direct bearing on inflation the
more money in an economy and the fewer
goods and services there are are they
able to buy the further the price of
those goods and services to be pushed up
okay so you know if I put a central bank
in here somewhere
governing all activity in financial
terms on the island two things arguably
it could
to influence one would be that and the
other would be whether that's 10% or 20%
so what are the mechanisms available to
a central bank to influence the money
supply because the more money you have
in an economy as I say the more it's
going to fight the limited supply of
goods and services on this island and
that's going to tend to push up the
price so that has an inflationary impact
okay very quick summary and we're seeing
some of this in action sort of at the
moment so basically three tools that can
be used to influence what's going on in
my scenario here if you're a central
bank number one is um something called
the discount rate all right basically in
short there are io u--'s out there that
don't carry an interest rate okay and
the way that the central bank can
influence that is if I asked you what
you would effectively what you would
deposit now to get a thousand pounds in
a year's time
if interest rates in the meantime 5%
then the answer is right now you only
need to pause it around nine hundred and
fifty two pounds okay and there are
financial instruments out there
io u--'s bonds they don't carry an
interest rate you buy them for one price
and cash them in another political
discount instruments and basically the
price is influenced by that money market
interest rates so central banks can
influence the size of that discount rate
they can not - in practice this bit of a
clumsy tool but they can do the second
thing they can do on my little island is
to change that reserve rate if you make
banks hold back more money who knows if
you up the reserve rate from ten to
twenty percent you instantly shrink
potentially okay your monetary base now
that's a pretty blunt tool it's not done
normally very often that way you can see
that under fractional reserve banking
the fraction matters okay because I
talked about creating a thousand pounds
with a rate of 10 percent 500 pounds the
rate twenty percent so that's a tool
number two and tool number three which
is the one that's used most often it is
the open market operation which is a
grand sounding title for what boils down
essentially to buying and selling bonds
okay
I'll just wrap up by explaining how that
works now I'm not going to drift into
Operation Twist or quantitative easing
because other videos on those precise
topics but in essence the other way you
can influence the money supply as a
central bank is by buying and selling
the government io u--'s if you like
here's the principle okay if you sell a
lot of government io u--'s people want
to buy them because they're safe they're
a nice place to put your money
especially they're issued by the
American or the UK government for
example so the idea is you sell io u--'s
commercial organizations and banks bid
for them and buy them that sucks
money out of the banking system into the
central bank okay
reducing the supply of money in the
economy because that money is being used
to pay for these IOUs
all right and if there's less money in
the economy then the price of it will
change okay so the theory is that
interest rates will rise slightly so by
basically selling io u--'s okay that's a
government
IOU use the idea is that you t-bills and
so on you suck money out of the banking
system because people got to pay for
them so now they want to pay for them as
a kind of safe haven and so on and
that's going to reduce the money flowing
around the banking system and therefore
increase the price of money so that will
have an impact all right alternatively
if the government fired central bank
decides to start buying back these IOUs
paying them off if you like that's going
to release central bank funds and via
the people you buy them into the economy
that means there's more money flying
around the economy in theory and that
will tend more money to push the price
down okay
so that will tend to reduce the price of
money or reduce interest rate right so
basically those are the three main
mechanisms by which the central bank
will attempt to influence supply and
potentially the price of money as well
and as I say the one that tends to use
most commonly at these three weapons is
that one
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