I thought I'd already explained in very basic terms that the talk of banks "creating money out of nothing" is just not true.

I'll have another go.

I have just set up Bank of FA (quite a fitting moniker, I thought)
You are my first customer

You want to borrow £10K from my bank, so I lend you it. All this means is your loan account is credited with 10K. BUT, and this is the point that most people miss, no money has been "created" - because whereas previously you had no money, now you have got MINUS 10K. You owe it to my bank! the two cancel out. No money has been created.

In due course you repay your loan. You, your bank, and the total sum of money are now squits, nothing created, nothing lost, except that the bank has made you pay a fee (interest and bank charges) for the privilege, so to that extent, they are in front, but that is money for services rendered, paid out of your income, again it is not money that has been "created".

So the repayments are profit? As an example say I borrow £10,000 for 12 months at a rate of 6.7%. The bank creates that money. At the end of the 12 months the total amount I will have paid the bank will be £10,355.76. This £10,355.76 is the profit (ignoring any admin/staff costs etc.) the bank has made on the loan? This money is now sat there in the bank's reserves for it to do with as it pleases?

No, they "gave" you 10K, you've returned it. The two cancel out, obviously.

Do the bank get chicks for free though?

It's a well accepted principle that fractional reserve banking increases the money supply and this is often referred to by economists as money creation.



There are two things missing from your example. Where the bank got that £10K from in the first place and what happens to it after it lends it.

If this is the first bank in the chain it will have got it from the central bank who will have taken it out of the money supply or created the money sometimes by printing it. It will have had to stash some money it got from them on reserve and it can lend the rest on.

To keep it simple lets say it got 10K from the central bank and it must keep 10% on reserve. That means it can lend £9K on.

It lends £9K to another bank and they do the same thing. £900 is put on reserve and £8100 is lent on.

So the amount lent out is £17,100 (£9K+£8.1K). But we only had £10K to start with. So the lending process has created £7,100.

The deposits (the £10K and the £9K) represent each banks liability, the loans its assets. So for example given the second bank has liabilities of £9K but reserves of £900 plus assets of £8.1K its balance sheet is sound.



The interesting question is where does the money to pay the interest come from? Out of thin air?

I agree with your explanation of fractional reserve banking but the OP doesnt, he (because he has misunderstood things he has read and heard) thinks that they need no money at all in their reserves in order to lend money, he thinks they literally lend as much money as they want because it all compeletely comes from nowhere.

I agree with Charlie Sheen, that ain't working.

As FA says, the loan capital cancels out. Only the interest is added to the net worth of the bank.

In my case it comes from my employer in the form of wages.

It's no wonder we got into bother if bankers use faulty maths like that.

The same place the money comes from to pay for any goods or services. Interest is simply the bank's mark up on the service it supplies just like a shop's mark up. There's nothing magical about interest or indeed about money which prevents it from being traded like anything else.




Cheers, however I am aware of what happens in reality. I was just intrigued as to how it works in the fictional scenario of banks creating money from nothing.

Please explain. I was trying to show that despite the central bank only depositing £10K the two banks managed to lend a total to £17.1K so £7.1K had been "created" in economic terms.

I think what is deemed to be the "money supply" is actually greater than that as it includes the amounts held on reserve by the commercial banks (but I am not sure about that).

I think you missed the point. The money that exists in the economy has to come from somewhere and by this I mean not your piggy bank or from your employer. All money in the economy is created in some way. Some of it is created by the mechanism I described.

While the o/p got it wrong for the reasons Cookridge_Rhino pointed out there are people who argue our fractional reserve banking system is a debt driven mechanism akin to a ponzi scheme because it relies on new borrowers perpetually entering the system.

Another argument against it is that it is inherently fraudulent because the banks promise to pay depositors their cash on demand but have not got a hope in hell of doing so. They rely on a run on the banks never happening but some economist argue that isn't such an unlikely event e.g. Northern Rock.



It is not fictional in that commercial banks do create money as I described which again as Cookridge_Rhino pointed out is not what the o/p meant.

Nothing was created other than the original deposit of 10k. The amount of money available to the real economy is less than the amount originally created. Money has moved, and the amount has reduced on each move as some has been retained. Adding it all together as in your example is flawed maths.

BTW I'm not suggesting that accountants don't look at things the way you described. I'm stating that it's made-up nonsense and in no small part responsible for the mess we're in now.

Not in economic terms it isn't. The money supply available is the amount deposited. So that is the original £10K in my example plus the £9K loaned to the second bank. Increasing the money supply like this is said to "create money" because it is active in the economy.

If the second bank loaned its £8.1K out to me and I kept it al in cash that is where "money creation" stops but the money supply is still £19K )not £17.1K as my previous post may have implied).



Oh OK. It is certainly how economists look at it. Of course the money banks lend doesn't just come from the central bank (the original £10K in my example) but from ordinary depositors as well but the fact is they only keep a fraction of what is deposited in reserve and loan out the rest and when they do you get what I tried to illustrate.

I think an interesting thing about this is it shows what is supposed to happen when the Bank of England prints money. They deposit it with the commercial banks with the idea they will lend it on as explained. The trouble is they then tell the banks they need to hold bigger reserves and add to that no one wants to borrow at the moment hey, presto "quantitative easing" as they call it doesn't work. In fact what the banks often do is use the money to buy government bonds! So all this new money doesn't find its way into the economy which is why Alistair Darling said the other day the B of E needs to stop quantitative easing until the banks play ball.