Money, Banking, and Credit

Why this matters

Much of the spending in GDP and How It Is Measured is paid for with credit: mortgages for houses, loans for business investment, cards for consumption. Credit expands in good times and contracts in bad ones, and the swing amplifies the economy's ups and downs. Banks sit at the centre of it, which makes them both essential and fragile. For an investor, understanding how money and credit are created explains a good deal about interest rates, inflation, recessions, and why bank shares behave the way they do.

What counts as money

Money is whatever people accept in payment, use to measure prices, and hold to spend later. In practice that's two things: the notes and coins issued by the government and central bank, and the balances in bank accounts. The second is by far the larger. The Bank of England describes how the majority of money in the modern economy is created by commercial banks making loans.¹

The US measures its money supply in aggregates. The broad one most often quoted, M2, adds small time deposits and retail money market fund balances to the currency and readily available deposits counted in M1.²

How a bank creates money

The common picture is that banks take in savers' deposits and lend them out. The Bank of England calls that a misconception. When a bank makes a loan, it simultaneously creates a matching deposit in the borrower's account, which is new money.¹

Bank's balance sheet	Assets	Liabilities
The loan is made	Loan to the borrower: +$300,000	Deposit in the borrower's account: +$300,000
The borrower pays the seller, who banks elsewhere	Reserves: −$300,000	Deposit: −$300,000
The seller's bank	Reserves: +$300,000	Seller's deposit: +$300,000

No saver's money was handed over. A loan and a deposit appeared together, and the deposit moved to the seller's bank, which now holds $300,000 more in deposits than before. Across the banking system, the money supply has grown by $300,000.

The reverse is also true. When borrowers repay loans, money is destroyed: the deposit used to repay disappears along with the loan.¹ The money supply grows when new lending outpaces repayments and shrinks when it doesn't.

What stops banks creating unlimited money

Commercial banks can't create money freely without limit.¹ Several things hold them back.

• Profitability and interest rates. A bank lends when the loan is expected to be profitable at the interest rate it can charge. The central bank influences those rates, which is its main lever on the amount of money created.¹
• Borrowers. Lending needs people and businesses who want to borrow and can repay.
• Losing deposits. When the new deposit moves to another bank, the lending bank has to settle in reserves, as in the table above. A bank that lends much faster than its rivals keeps losing reserves to them.
• Regulation. Capital rules require banks to fund part of their assets with shareholders' money, which caps how far they can expand on a given amount of capital.

The textbook story of a fixed "money multiplier" on the central bank's reserves doesn't describe current practice, the Bank of England explains.¹ In the US, the Federal Reserve reduced reserve requirement ratios to zero effective 26 March 2020, eliminating reserve requirements for all depository institutions.³

The rest of this lesson is for members

Still to come in this lesson: What the central bank controls, The money supply from 2020 to 2024, Why banks are fragile, The credit cycle, the key takeaways, and 2 quiz questions with explanations.

Membership opens every lesson in the curriculum, the capstone projects, the interactive tools, and the members-only channels in the Hyperion Entities Discord. The first lesson of every module stays free.

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