How Is Money REALLY Created? (Probably Not How You Think)

  1. This ability to create Reserves has led many to believe that Central Banks can create money at will, and is hence at the root of the hysterical choruses of “hyperinflation is coming” with each new iteration of QE. (Spoiler alert: the hysteria is
  2. And…unfortunately for the multitude of people who believe that money is created via Fractional Reserve Banking, Reserves are
  3. The answer is …
  4. But, if Fractional Reserve Banking does not work because
  5. Although, it must be asked, if QE works… then why are Central Banks doing it for a 2nd, 3rd, 4th…
Central banks and the banking system what are bank reserves?

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For something as important to daily life as money, very few people know how it is actually created. And, no, money isn’t created via fractional reserve banking. It is actually, literally, created from nothing.

Before we get to explaining just how such a feat is possible, we have to cover a few basics, beginning with Bank Reserves.

Introducing Bank Reserves

What are they?

Simply put, Bank Reserves are how banks settle transactions (bank transfers from one client to another) between each other.

When a customer deposits $100 in Bank A, Bank A’s total Reserves increases by $100, and its liabilities increase by $100. Deposits are liabilities from a bank’s perspective because deposits are funds that they owe to customers:

bank balance sheet customer deposits cash in bank debit reserves credit deposits

Now, when the customer transfers $100 to a friend who holds an account in a different bank, Bank B, Bank A has to transfer its Reserves to Bank B:

bank reserves accounting between two bank balance sheets when funds are transferred between banks

This transfer is done via the Fed, where US banks have accounts holding Reserves for just this purpose — to settle transactions amongst themselves. Banks in other countries will have accounts with their own domestic Central Banks, with their Reserves denominated in their own domestic currencies.

Different Central Banks have different policies, but in general, banks do not transfer reserves between each other every time a transaction is initiated. Instead, they do it on a net basis at the end of the day, simply because it is a lot more convenient. This practice also means that individual banks in the financial system will have vastly differing needs for Reserves at the end of each business day.

These differing needs create demand and supply in the domestic interbank market for Reserves, where banks lend/borrow Reserves from each other in order to meet their daily business needs. Naturally, such a market will have its prevailing interest rate, a good example of which is the Fed Funds target rate that market folks always talk about.

Since domestic banks must have Reserve accounts with their respective Central Bank in order to settle transactions with their counterparty banks, Central Banks can, and do use Reserves as a means to achieve their respective monetary policies.For example, they can create them by purchasing assets from domestic banks, a la QE, or destroy them by selling assets to domestic banks.

This ability to create Reserves has led many to believe that Central Banks can create money at will, and is hence at the root of the hysterical choruses of “hyperinflation is coming” with each new iteration of QE. (Spoiler alert: the hysteria is unfounded)

Some central banks also have a Reserve requirement ratio (RRR), which requires banks to hold a certain percentage, say 10%, of their deposit liabilities in their accounts at the Central Bank.

Different Central Banks implement such a rule for different reasons , some, such as the People’s Bank of China (PBoC), use the RRR as an important tool to manage their domestic money supply. Others have given up on the RRR altogether, setting them at zero, including the Bank of England (BoE) and more recently, the Fed.

So why the differing approaches?

This is where the role of Reserves in the financial system and wider economy becomes a little bit more complex, and a lot more misunderstood.

Enter: Fractional Reserve Banking

Photo by Jonathan Cooper on Unsplash

Ostensibly, the RRR was created to provide a liquidity buffer to ensure that a bank had reserves to cover customers rushing to move their funds out of that bank. In other words, a bank run.

This is possible because banks in this day and age are theoretically “supposed” to be lending out their Reserves in order to create money in the economy.

The theory goes that a bank takes $1000 in deposits, keeps 10% to fulfill the RRR, and loans out the remaining $900. The loan increases the money supply in the system by $900, since the initial depositor still has $1000, and the loanee has $900.

The bank, by originating a loan, has created $900 in new money.

Now, the $900 is spent by the loanee and deposited into a second bank. This second bank now keeps 10% of the $900, which is $90, and loans out the remaining $810.

In originating this second loan, the second bank creates another $810, thereby increasing money supply again.

This goes on until the theoretical maximum of the money multiplier, defined as 1/RRR, in money is created.

Table showing how money is created in the banking system under the theory of Fractional Reserve Banking’s Money Multiplier

The theoretical process described above is known as Fractional Reserve Banking; fractional because a fraction is kept in reserve and the remainder loaned out.

Banks are susceptible to runs since they never hold the full amount of Reserves that its customers have deposited. However, while the RRR is an important part of how Fractional Reserve Banking (FRB) works, it isn’t the foundation upon which the model is built upon.

Instead, the foundation of Fractional Reserve Banking is the underlying assumption that Reserves are loaned out; because if this assumption were proved to be false, then money simply will not be created in the banking system and the wider economy.

And…unfortunately for the multitude of people who believe that money is created via Fractional Reserve Banking, Reserves are not loaned out.

How Money Is REALLY Created (The Myth Of FRB)

Photo by Visual Stories || Micheile on Unsplash

The Fractional Reserve Banking (FRB) model is very deeply ingrained in today’s mainstream economic thinking. This model is taught in introductory macroeconomic classes across the globe, and has been for years. Which means that every graduate, regardless of their degree, has at least heard about this if they took intro econ classes. That’s a lot of graduates.

Now, you may be asking: Isn’t it good that many people are familiar with the FRB model? Isn’t it better for society if more people are familiar with how economic policy makers think?

Well the answer to the second question is yes.

The answer to the first question however, is a resounding no, because as it turns out, Fractional Reserve Banking is not what actually happens in the real economy, because banks do not lend Reserves.

This, of course, begs the question: How then is money created in the banking system and economy?

The answer is … ex nihilo. Which is Latin for “from nothing”. Here’s the accounting:

balance sheet accounting of how money is really created via new loans, reserves are not lent out because banks do not lend reserves

Like in FRB, lending is the mechanism through which money is created; unlike FRB, Reserves are not loaned out. In fact Reserves are not present anywhere in the accounting for new loans. This is important because for FRB to work, banks must loan out Reserves, which means that Reserves should appear somewhere in the accounting, but they do not.

Instead, when a new loan is made, the bank creates a new asset for the loan, since they will be earning interest on it, and they balance this by increasing the deposit balance of the client who took out the loan.

From the client’s perspective, their deposits increase by the amount of the loan, and their liabilities increase by the same amount, since they now owe the bank the amount of the loan.

As can be seen, Reserves are not part of the process at all. Instead, when a new loan is originated by a bank, money is created through making the appropriate balance sheet entries — from nothing.

At this point, it would be completely understandable if you think that everything written above is incorrect, or some sort of misguided attempt at creating fake news. So don’t take our word for it; here’s the Bank of England explaining it in a research paper.

Of course, this new understanding of how money is actually created raises a lot of questions. What use do Reserves have since they aren’t lent out? Doesn’t this invalidate QE? What does this mean for modern monetary policy?

Implications, Ramifications, And More Questions

QE prints reserves which does not reach the broader economy because reserves are not lent out. QE does not work

Modern monetary policy is based largely around Central Banks expanding/contracting the amount of Reserves in the banking system. This is done through smaller open market operations to influence overnight interest rates for borrowing/lending Reserves, and larger operations like QE.

The logical basis for these operations is that if the Central Bank increases/decreases the amount of Reserves held by banks, then banks will in turn loan more/less of these Reserves out into the economy, thereby influencing economic growth and generating the “good” kind of inflation.

But, if Fractional Reserve Banking does not work because banks do not lend Reserves, doesn’t that mean Central Bank policy, i.e. QE, does not work as advertised?

Unfortunately for all of us, the answer to the above question is Yes.

Take a moment and consider the ramifications of this — that 1) Central Banks do not understand how money is created, or 2) they do understand it but are not tailoring their policies to reality.

If 1) is true, then what good are these QE loving Central Banks doing? If they do not understand the very basics of how the system they are overseeing works, that means all their future monetary policies are dead on arrival, not to mention the decade(s) already gone.

If 2) is true, then it begs the question — Why? A possible reason is that Central Banks feel the need to be actively doing something, which is after all a very normal emotional reaction all humans have in times of crisis.

After the rubicon of implementing QE for the first time is crossed, each subsequent iteration then becomes easier to implement; it becomes a convenient solution of sorts.

There is of course, an even scarier reason. Central Banks actually think that QE works.

Although, it must be asked, if QE works… then why are Central Banks doing it for a 2nd, 3rd, 4th… nth time?