The Money Multiplier Effect

Contrary to what most people think, banks do not simply take in deposits on the promise of interest, and loan these deposits out for higher interest.  That is a simplistic understanding of retail banking.  Once we factor in non-performing loans, currency exposure and other forms of risk and costs, the revenue is not much. 

What banks actually do is play with the balance sheet.  When a bank issues a loan, it credits that amount as an asset on the balance sheet.  This same amount can be transferred to another bank, or even a different part of the same banking group as a liability.  Although no new physical money is actually created, we have a new deposit, meaning new money is actually added to the banking system. 

Of course, there has to be a limit to how much money can be created out of nothing, and added to the system.  This is the reserve requirement that central banks impose on the banks.  The reserve requirement is the amount of funds a bank needs to hold in reserve to ensure it can meet liabilities in case of sudden withdrawals.  The level of reserve requirements is a tool of monetary policy.  It is a means used by the central bank to increase or decrease the money supply in the economy, and therefore influence interest rates. 

Within its reserve requirement, any bank can lend directly from any new deposit.  For example, if the reserve ratio is 10 percent, and the bank’s new deposit is US$1 million, the bank can now lend out US$909,000 which can be deposited with another bank.  This creates another new deposit, which can be used to lend out another $819,000 dollars.  This can be repeated ad infinitum, creating an effect we call the “money multiplier”.  In effect, the total money supply is unlimited.  None of this money exists physically.  There is a tenuous link to GDP and economic activity since borrowing depends on this.  Because there is no actual underlying commodity to back this money, the system goes through a cyclical correction we recognise as market crashes.