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How Banks Create Money Out Of Thin Air

Jan 11, 2008
Banks manufacture money. They exist to make money. Bankers know how to create money out of thin air. It's true that banks provide essential financial services, such as bank accounts and loans. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money, using customer deposits.

At this point, the choice of vocabulary is critical. Banks are not just "earning" money. Banks are actually "creating" new money.

Imagine that you deposit $100,000 into a one-year Certificate of Deposit at 5% interest. The bank now can use your $100,000 to create loans.

The Federal Reserve sets the reserve rate for the bank from 3-10%. A 3% reserve rate means that the bank must keep 3% of the $100,000 on reserve and can loan the remaining 97%. A 10% reserve rate means that the bank must keep 10% of the $100,000 on reserve and can loan the remaining 90%. For our example, let's assume that the reserve rate is 10%. This allows the bank to loan $90,000 of your $100,000 deposit.

So, the bank makes Loan #1 of $90,000 and keeps $10,000 on reserve. This is the critical point where the bank creates money. According to the bank's balance sheet, the $90,000 loan to the borrower is also a $90,000 asset for the bank. By its own brand of money magic, the bank has created $90,000 out of thin air.

The bank does not have to stop with one loan. Since it now has an asset worth $90,000, it can use this asset to make another loan. Again, it must keep 10% on reserve, which means that it can loan 90% of the $90,000. So the bank makes a loan of $81,000. Once again, the bank has created money out of thin air. The $81,000 loan becomes an $81,000 asset.

You guessed it. The bank can use this $81,000 asset to make another loan. It keeps 10% on reserve, and makes a loan of $72,900. And once again, the loan to the borrower becomes an asset to the bank. The bank now has another asset, worth $72,900.

Even though the Federal Reserve allows banks to make five to six loans based on the original $100,000 deposit, we'll stop at three. Each new loan is a new asset, which means new money for the bank. Let's add up how much new money the bank created.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000 Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

This example is oversimplified, but the principle behind the example demonstrates how banks create money out of thin air. When you deposit your money into the bank, it goes into a pool of money available for the bank to make loans. When the bank creates a loan, it creates an asset. This asset is new money.

The purpose of this example is to demystify money. You and I cannot do what banks do. We can't make multiple loans based on the same money. The value of seeing how banks use customer deposits to create money is to understand how money is created.

The critical point is to see that money is not a commodity. Money is not equivalent to currency. Money is created in money-making transactions.

So, if you want more money, think the way bankers think. Ask how you can use money to create more money. If you really think the way bankers think, you will use someone else's money to create more money. The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited.
About the Author
Kalinda Rose Stevenson, Ph.D. Discover the difference between earning money and making money in a real estate investing book, "No Money Limits." Visit http://www.NoMoneyLimits.com for your Free "52 Heart of Money Insights."
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