How a Bank Loan Create More Money
A bank loan puts more money into the financial system by creating new money through the process of credit creation. Here’s how it works:
1. The Loan is Issued
When a bank approves a loan, it does not pull existing money from its reserves or from customer deposits to lend to the borrower. Instead, the bank creates a new deposit in the borrower’s account equal to the loan amount. This deposit is considered money, as the borrower can use it for spending, investing, or other purposes.
2. Money Supply Increases
The newly created deposit adds to the total money supply in the economy. While the bank records the loan as an asset (the borrower’s promise to repay), the deposit is a liability (the money the bank owes to the borrower). From the borrower’s perspective, the money is real and can be spent immediately.
3. Multiplier Effect
When the borrower spends the loan—for example, to buy a car or start a business—the recipient of that payment deposits the money into their own bank account, often at a different bank. This triggers a cycle:
• Banks keep only a fraction of deposits as reserves (as required by regulations or policy) and lend out the rest.
• Each round of lending creates more deposits, further increasing the money supply.
This process is referred to as the money multiplier effect, although in practice, the ability of banks to lend is often influenced more by credit demand and regulatory requirements than by reserves alone.
4. Debt and Money Coexist
The key insight is that when a loan is made, both the loan (a liability for the borrower) and the deposit (new money) are created simultaneously. The borrower’s repayments gradually destroy this money as they reduce the loan balance, but until the loan is repaid, the created money circulates in the economy.
5. The Role of Central Banks
Central banks indirectly regulate this process by setting reserve requirements, interest rates, and other monetary policies. These factors influence how much money commercial banks are willing and able to create through lending.
Example:
If a bank lends $100,000 to a business, it creates a $100,000 deposit in the business’s account. The business uses the funds to pay for equipment, wages, or supplies, injecting the new money into the economy. Even though the borrower owes the bank $100,000 plus interest, the money now exists in the financial system, facilitating economic activity.
This mechanism—credit creation by banks—is why banks are often described as “money creators” rather than just intermediaries of existing funds.
Oddbean new post about login | logout