Two misconceptions about money creation
The vast majority of money held by the public takes the form
of bank deposits. But where the stock of bank deposits comes
from is often misunderstood. One common misconception is
that banks act simply as intermediaries, lending out the
deposits that savers place with them. In this view deposits
are typically ‘created’ by the saving decisions of households,
and banks then ‘lend out’ those existing deposits to borrowers,
for example to companies looking to finance investment or
individuals wanting to purchase houses.
In fact, when households choose to save more money in bank
accounts, those deposits come simply at the expense of
deposits that would have otherwise gone to companies in
payment for goods and services. Saving does not by itself
increase the deposits or ‘funds available’ for banks to lend.
Indeed, viewing banks simply as intermediaries ignores the fact
that, in reality in the modern economy, commercial banks are
the creators of deposit money. This article explains how,
rather than banks lending out deposits that are placed with
them, the act of lending creates deposits — the reverse of the
sequence typically described in textbooks.(3)
Another common misconception is that the central bank
determines the quantity of loans and deposits in the
economy by controlling the quantity of central bank money
— the so-called ‘money multiplier’ approach. In that view,
central banks implement monetary policy by choosing a
quantity of reserves. And, because there is assumed to be a
constant ratio of broad money to base money, these reserves
are then ‘multiplied up’ to a much greater change in bank
loans and deposits. For the theory to hold, the amount of
reserves must be a binding constraint on lending, and the
central bank must directly determine the amount of reserves.
While the money multiplier theory can be a useful way of
introducing money and banking in economic textbooks, it is
not an accurate description of how money is created in reality.
Rather than controlling the quantity of reserves, central banks
today typically implement monetary policy by setting the
price of reserves — that is, interest rates.
In reality, neither are reserves a binding constraint on lending,
nor does the central bank fix the amount of reserves that are
available. As with the relationship between deposits and
loans, the relationship between reserves and loans typically
operates in the reverse way to that described in some
economics textbooks. Banks first decide how much to lend
depending on the profitable lending opportunities available to
them — which will, crucially, depend on the interest rate set
by the Bank of England. It is these lending decisions that
determine how many bank deposits are created by the banking
system. The amount of bank deposits in turn influences how
much central bank money banks want to hold in reserve (to
meet withdrawals by the public, make payments to other
banks, or meet regulatory liquidity requirements), which is
then, in normal times, supplied on demand by the Bank of
England. The rest of this article discusses these practices in
more detail.
Money creation in reality
Lending creates deposits — broad money
determination at the aggregate level
As explained in ‘Money in the modern economy: an
introduction’, broad money is a measure of the total amount
of money held by households and companies in the economy.
Broad money is made up of bank deposits — which are
essentially IOUs from commercial banks to households and
companies — and currency — mostly IOUs from the central
bank.(4)(5) Of the two types of broad money, bank deposits
make up the vast majority — 97% of the amount currently in
circulation.(6) And in the modern economy, those bank
deposits are mostly created by commercial banks
themselves
