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(temporarily hidden — click to expand)
How Loans Create Money

How Bank Loans Create Money -- Explained Visually in About 5 Minutes

Meet Joe.
This is Joe's household balance sheet. On the left are assets -- $50 of bank deposits. On the right are liabilities. Joe has no debt, so his net worth is $50.
Joe wants to buy a used car and applies for a $100 bank loan to do so.
Joe's loan is approved! His bank account increases by $100. His assets now total $150 (he has not yet bought the car). However, Joe now has $100 in debt to the bank, recorded as a liability.
Net worth is assets minus debts. Joe's net worth is still $50.
What do you think happened to the bank's balance sheet? Did the bank's assets shrink by $100 when it made the loan, leaving it with less money to lend to other borrowers? The truth is very counterintuitive and nothing like this piggy bank! Please maximize your browser and click "Next" at the top of the page to find out more...

Next we'll look at the bank's balance sheet before issuing the loan, and then consider the question, "What is Money?":

To keep things simple, let's pretend Joe is the only customer of this bank. On the left, as assets, the bank has $100 in reserves. These are a special kind of money (called "base money") supplied by the central bank. On the right, as liabilities, the bank has $50 in deposits, reflecting Joe's bank account balance.
Mouse over the deposits on either balance sheet to highlight how they are linked -- for every financial asset there is a corresponding liability, and vica versa!
So, what is "money"? Money is a kind of financial asset used for spending that exists because someone else has a matching debt! (Remember, debts are also called liabilities.) Joe's bank deposits are money, and they depend upon the bank's offsetting deposit liability!
What about physical cash you can put in your pocket? It has a matching liability too -- at the central bank! (For example, the US Federal Reserve). We'll discuss cash later, but it's the minority case, since most money in the economy is in the form of electronic bank deposits.

This time let's watch the bank's balance sheet as we re-play the loan being issued:

The bank's assets increase by $100 because it has added a new loan asset. (What Joe owes the bank is considered an asset of the bank.) Its liabilities increase by $100 because it has $100 in new deposits as a result of the loan crediting Joe's bank account. Its net worth has not changed.
Here is the new money created by the loan -- Joe's additional $100 of deposits.
Here's the really counterintuitive part -- the bank's reserves didn't go anywhere! Banks' ability to issue new loans has no dependency on their quantities of reserves, so Joe's $100 loan didn't "use up" the banks' reserves or prevent the bank from issuing loans to other people too.
If lending creates money and is not limited by reserves, what stops lending from spiraling out of control? Sometimes, like the lead up to the recent financial crisis, it can become excessive, but usually there is a very important limiting factor...

Next we consider the limiting constraint in bank lending, then put you in the "driver's seat" to control the balance sheets:

Hands On Interactive Exploration:

Invalid Action: One or more balance sheets has insufficient assets or liabilities. Try another action first or reset the balance sheets.

The real constraint on bank lending is finding credit-worthy borrowers. If a borrower defaults on a $100 loan, the bank loses $100 of net worth! So banks have to be careful to extend loans only to customers deemed likely to repay them.
Please experiment with the loan-related buttons in the sidebar that demonstrate these concepts. You get to interactively alter the balance sheets.

Still wondering why loans create money?

More Details on Bank Lending:

Wondering about the implications of aggregating these "micro" examples to the "macro" economy?

  • Reserve requirements
  • Capital requirements
  • Customers withdrawing loan proceeds as cash (currency) — economy-wide implications

The next tutorial will show why the above three things don't limit the degree to which banks on aggregate issue loans! You'll see why, contrary to some beliefs such as textbook descriptions of fractional reserve banking and the money multiplier, government does not control the quantity of money or lending!

Click NEXT again for a link...

Let's walk through the scenario of a loan disbursed as cash, even though bank loans are usually credited as electronic bank balances.
Cash (such as in a bank's vault) is often called "currency". "Bank reserves" are technically a mix of two things: "currency" and electronic "reserve balances".
When the loan is issued, the bank's currency asset is replaced with a new loan asset.
At the same time, the borrower receives the currency asset (and incurs a matching debt to the bank). Technically, this is "new money". Why? Currency is always part of base money supply no matter who holds it, but when held outside banks it also counts toward broad money supply. (Part 2 will explain why there's more to this than semantics and "double counting".)
Now let's watch the borrower deposit the currency with the bank. The borrower's asset is replaced by a bank deposit, which also counts in broad money supply, so the new money is still present in the economy.
When the customer deposits the currency, the bank gains a currency asset and a matching deposit liability.
These arrows show the full circle the currency moved in. This "borrow currency then deposit currency" process is equivalent from a balance sheet perspective to the electronic loan process shown on previous pages in which reserves never leave the bank's balance sheet.
To step back... As economist Hyman Minsky said, "Anyone can create money, the problem is getting it accepted." Banks are regulated by federal government and their power to create money comes from the liabilities they issue (bank deposits) being widely accepted as payment for goods and services (via debt cards, checks, etc).

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Ready to Learn More?

The following tutorial covers some of the economy-wide implications of bank lending:

Why Central Banks Don't Control the Money Supply: A Visual Tour of the Macroeconomic Dynamics of Bank Loans, Reserve Requirements, Capital Requirements, and Cash Withdrawals

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Other Tutorials:

How the Economy Works -- A Visual Tutorial (beginner+)

Macroeconomic Balance Sheet Visualizer (intermediate+)

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