The process of money creation and the evolution of our current banking system are best explained using stories. One such popular story is the story of a goldsmith. Let’s assume a goldsmith by the name Mark, operating from a small city.
Mark is the only goldsmith in his city, and has a strong vault where he stores his own gold and also other people’s gold. For safekeeping, people will come and deposit their gold with Mark, for which Mark will charge them a small fee. For record purpose, Mark will issue them a receipt, which they can come and produce anytime to Mark and take their gold back. Many people deposited their gold with Mark and held these receipts. As time passed, people started using these receipts for payment purposes or for paying their debt. For example, someone may buy food from a shop and pay using Mark’s receipt. The shopkeeper will then go to Mark and exchange the receipt for gold. The receipts were actually circulating as money. These receipts can be called bank loans.
One day Mark realized that on any given day only a small percentage of these receipts were cashed in for gold. This means that Mark could easily loan out a portion of the gold to people who need money without disturbing his daily gold needs. One day, Denis, a neighbor, came and asked him for a loan. Mark assessed his situation and the purpose of the loan, and after he was convinced, gave him a loan in the form of a receipt. Note that this is a loan because Mark did not take gold for him to issue the receipt. The receipt was given on the promise that Denis will come back and return the receipt after a few days along with a profit in the form of interest. This way Mark started lending out portions of deposits to earn interest. Mark was actually able to create money on the basis of trust. This is what became the foundation of the modern banking system, called “Fractional Reserve Banking.”
Let’s now look at how it works in the modern world.
In the fractional banking reserve banking system, the bankers will keep a percentage of deposits as reserve. Each country stipulates a minimum percentage that must be kept as reserve.
The rest of the money can be given as loans. When a borrower borrows money from a bank, he may spend it to buy something, and the seller who receives the money from the buyer/borrower may again deposit it in the bank. This money is again available with the bank to loan out (except the portion that must be kept as reserve). This process of lending, spending, deposits, and again lending can continue in cycles and finally the money loaned out will be a multiple of the original deposit amount.
Assume that a bank receives a deposit of $1,000, and it’s required to keep a reserve of 10% (reserve requirement). The bank will keep $100 in reserve and loan out $900. The borrower pays this money to someone and that person deposits this money back in the bank (the same or other bank). From this $900, the bank keeps $90 as reserve, and loans out $810.
As this process continues, using this initial deposit of $1,000, the bank will be able to expand this money to a total of $10,000 ($1,000 + $900 + $810 + $640 + … = $10,000).
The amount of money that can be created depends of the reserve requirement. The higher the reserve requirement, the less money can be created. For example, if the reserve requirement were 20%, the bank would have been able to expand the initial deposit of $1,000 only up to $5,000.
How much money can be created can be easily calculated using the concept of money multiplier, which is the reverse of the reserve requirement. For example, if the reserve requirement is 10%, then the money multiplier is 1/10%, or 10. So a cash deposit of $1000 can create money of 10 times that.