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The way in which banks create and generate capital is a commonly misunderstood system. Banks are heavily regulated both in Canada and Internationally, and their ability to create money is heavily influenced by global financial trends.

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How the Bank of Canada Creates Money Through its Asset Purchases

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Executive Summary

Money is created in the Canadian economy in two main ways: through private commercial bank loans or asset purchases, and through the Bank of Canada's asset purchases. The majority of money in the economy is created by commercial banks when they extend new loans, such as mortgages. However, with the Bank of Canada's unprecedented asset purchases to reduce the negative impacts of the COVID‑19 pandemic on the Canadian economy and to bring inflation back up to target, greater attention has been paid to the Bank of Canada's money creation and its impact on inflation. An examination of the differences between these two methods shows that money creation through asset purchases by the Bank of Canada is essentially an internal government process, mostly limited by inflation. The examination concludes that external factors, like financial market dysfunction, cannot cause the federal government to run out of money.

"The process by which money is created is so simple that the mind is repelled."
- John Kenneth Galbraith

1 Introduction

This paper explores the operational and legal aspects of how the Bank of Canada creates money by buying newly issued federal government bonds and Treasury bills. 1 It also discusses how private commercial banks create money.

To soften the negative impact of the COVID‑19 pandemic on the Canadian economy and to bring inflation back up to its target rate, 2 the Bank of Canada recently injected the largest amount of money in its history into the financial system. Through various asset purchase programs, the Bank of Canada has bought federal, provincial and corporate bonds, commercial paper, bankers' acceptances, Canada Mortgage Bonds, Treasury bills and short-term provincial securities. These asset purchases increased the size of the Bank of Canada's balance sheet from $120 billion on 11 March 2020 to a peak of $575 billion on 10 March 2021. After winding down some of its asset purchase programs, the Bank of Canada reduced its balance sheet to $478 billion on 12 May 2021. 3

Although these measures were taken in the most extraordinary circumstances of a global pandemic, the Bank of Canada also purchases financial assets as part of the regular management of its balance sheet to offset its liabilities, which consist mainly of bank notes in circulation and government deposits. 4

2 The Bank of Canada's Process for Creating Money Through Asset Purchases

The Bank of Canada helps the Government of Canada borrow money by holding auctions throughout the year at which new federal securities (bonds and Treasury bills) are sold to government securities distributors, such as banks, brokers and investment dealers. However, the Bank of Canada itself typically purchases some of the newly issued bonds and a sufficient number of Treasury bills to meet its needs at the time of each auction. 5 These purchases are made on a non-competitive basis, meaning that the Bank of Canada does not compete with the government securities distributors at auctions. Rather, the Bank of Canada is allotted a specific number of securities to buy at each auction. 6

In practical terms, when the Bank of Canada purchases government securities at auction, it means that the Bank records the value of the securities, each of which has a unique International Securities Identification Number, as a new asset on its balance sheet. It simultaneously records the proceeds from the sale of the securities as a deposit in the Government of Canada's account at the Bank - a liability on the Bank's balance sheet (see Appendix, Table 1).

Since the Bank of Canada is a Crown corporation - wholly owned by the federal government, yet independent of it in the conduct of its monetary policy - the Bank's purchase of a newly issued security from the federal government can essentially be considered an internal transaction. It records new and equal amounts on the asset and liability sides of its balance sheet, creating money through digital accounting entries. 7 The federal government can then spend that newly created money in the Canadian economy as it sees fit, subject to Parliament's approval.

The creation of money by the Bank of Canada through the purchase of assets like Government of Canada securities has fundamentally the same financial impact as the Bank making loans to the federal government, 8 yet the Bank's governing law, the Bank of Canada Act, 9 does not explicitly empower it to make loans of this nature. 10 Rather, this Act gives the Bank the power to "buy and sell securities issued or guaranteed by Canada or any province" (section 18(c)), as well as the power to "accept deposits from the Government of Canada and pay interest on those deposits" (section 18(l)). Taken together, these two provisions appear to empower the Bank to create money through the direct purchase of Government of Canada securities at debt auctions.

As the Bank of Canada explains, its purchases of Government of Canada securities are not a way of financing the government's spending and debt at no cost; the federal government has to repay the securities when they become due. Moreover, the Bank of Canada does not believe that its asset purchases since the beginning of the pandemic will generate high inflation rates, because the Canadian economy is currently facing low inflation. Its decision on when and how to scale back these purchases will be tied to the outlook for inflation. 11

3 Money Creation in the Private Banking System

Private commercial banks also create money when they purchase newly issued government securities as primary dealers at auctions. They do so by making digital accounting entries on their own balance sheets: the asset side is augmented to reflect the purchase of new securities, and the liability side is augmented to reflect a new deposit in the federal government's account with the bank.

However, it is important to note that the majority of money in the Canadian economy is created within the private banking system every time banks extend new loans like mortgages, consumer loans and business loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money (see Appendix, Table 2).

One key similarity between money creation in the private banking system and money creation by the Bank of Canada is that both are realized by simultaneously increasing the asset and liability sides of a balance sheet.

One notable difference between the two types of money creation is that there is no external limit to the total amount of money the Bank of Canada may create through its asset purchases, other than the impact the additional money created has on inflation. 12 In contrast, the amount of money that a private commercial bank is permitted to create depends on the amount of the bank's equity relative to its assets. The limiting rules, known as capital constraints, are established by Canada's banking regulator in a set of guidelines. 13 Another significant difference is that the key factor in a private commercial bank's decision to give a loan to a private entity is the creditworthiness of the borrower, whereas the key factor in the Bank of Canada's decision to purchase assets is its ability to achieve its inflation target.

4 Conclusion

Both the Bank of Canada and private commercial banks create money by making asset purchases or making loans. However, money creation by the Bank of Canada through purchases of Government of Canada securities is essentially an internal government process; this means that external factors, such as financial market dysfunction, cannot cause the federal government to run out of money. 14

Inflation is the main limit to the amount of money the Bank of Canada can create through asset purchases.

Notes

Appendix - Money Creation

Table 1 illustrates how the balance sheets of the Bank of Canada and the Government of Canada are affected when the Government of Canada issues new securities and the Bank of Canada purchases these securities directly.

Balance Sheet

Type of Entry

Bank of Canada

New Government of Canada securities purchased

New deposit from the Government of Canada

Government of Canada

New deposit at the Bank of Canada

New Government of Canada securities issued

Note: When the Bank of Canada purchases new Government of Canada securities, it simultaneously records the value of the securities as a new asset on its balance sheet and records the new deposit from the Government of Canada as a liability on its balance sheet. On the balance sheet of the Government of Canada, the new deposit at the Bank of Canada is recorded as an asset and the new securities issued are recorded as a liability.

Source: Table prepared by the Library of Parliament.

Table 2 illustrates how the balance sheets of a private commercial bank and a private entity are affected when that bank gives a new loan to the private entity.

Balance Sheet

Type of Entry

Private commercial bank

Loan to the private entity

Deposits created for the private entity

Private entity

Deposits at the commercial bank

Loan from the commercial bank

Note: When a private commercial bank provides a new loan to a private entity, it simultaneously records the value of the loan as an asset on its balance sheet and records the deposits created for the private entity as a liability on its balance sheet. On the balance sheet of the private entity, the deposits at the commercial bank are recorded as an asset and the loan from the commercial bank is recorded as a liability.

Source: Table prepared by the Library of Parliament.

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How the Bank of Canada Creates Money Through its Asset Purchases

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Money is created in the Canadian economy in two main ways: through private commercial bank loans or asset purchases, and through the Bank of Canada's asset purchases. The majority of money in the economy is created by commercial banks when they extend new loans, such as mortgages.

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Banks create money primarily through two functions.
The first is private commercial bank loans. These loans/securities are purchased by private banks (IE not the Bank of Canada) from the Bank of Canada. These securities are then sold by investment dealers, brokers, and banks to investors. These are often called bonds or Treasury bills.

The second method is through the sale of securities from the Government of Canada to the Bank of Canada. This essentially allows the government to get a loan from the Bank which must be repaid later in time.

I chose this article because it is a easily digestible and matter-of-fact article. The fact it is also published on a Government of Canada website makes it trustworthy.

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Apparently, a lot of people don't seem to know how money is created, and some of these are arguably people who should know. As much as 85% of British MPs were unaware that most of the money in the British economy is created by private banks, each and every time a loan is made, according to an article published by the Guardian just over a month ago.

The article reminded me of a quote attributed to Keynes that I came across while reading Geoffrey Ingham's The Nature of Money: "I know of only three people who really understand money. A professor at another university; one of my students; and a rather junior clerk at the Bank of England." I guess things haven't changed much.

Speaking of the Bank of England, I thought they cleared this one up back in 2014 in a paper titled, "Money creation in the modern economy," in which the authors clearly state on the very first page, "Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." But, I guess British MPs have better things to do with their time than worry about where money comes from, like gripe about how government budget deficits are going to heap unbearable burdens on future generations and important things like that.

All this got me wondering not only about whether Canadian MPs are similarly unaware, but also whether the Bank of Canada has released any documents as revealing as that issued by its British counterpart. Unfortunately, I did not come across anything as explicit. As for the status of Canadian MPs' knowledge of our monetary system, who knows? What I did find, however, was a short briefing published in 2015 by Canada's Library of Parliament titled, "How the Bank of Canada Creates Money for the Federal Government: Operational and Legal Aspects."
Where Money Comes From In Canada
After discussing how the Bank of Canada can create money for the Federal Government by participating in the Government's securities auctions and purchasing its debt, Penny Becklumb and Mathieu Frigon, the briefing's authors, go on to explain how private banks can also create money by effectively doing the same thing - buying the Government's debt at its auctions. But that's not all.

Private banks also create money by extending loans to private households and businesses. Here's what Becklumb and Frigon say: "it is important to note that money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's account, thereby creating new money."

Coincidentally, or not, the second sentence is almost word-for-word identical to the line in the Bank of England's report. I imagine that upon reading that report, Becklumb and Frigon were like me, wondering how things work in Canada, and then decided that it was worth informing Parliament about. If after three years, 85% of British MPs still don't get it, I don't imagine Canadian MPs are any closer to the truth either. I could be wrong.

Anyways, contrary to what British and Canadian MPs may have floating around in their heads, it is bank loans that create bank deposits, not the other way around. This may or may not be news to the rest of the population. If you've taken an economics class in which some portion of the class was devoted to money and banking, this is probably old news and is just what the money multiplier implied by a fractional reserve banking system explains, or purports to explain.

I agree that this is actually old news, but I disagree that this news is precisely what the money multiplier, fractional reserve banking and reserve ratio, explains. In fact the fractional reserve model assumes the exact opposite - deposits create loans.
The Fractional Reserve Banking Model
Suppose someone deposits $100 cash into their bank account. According to the fractional reserve model, the bank can now lend out a certain fraction of that $100 and must keep the rest of it on reserve. The amount kept on reserve is determined by the reserve ratio, which for this example I'll follow the standard macro textbook and say that it is 10%. That means the bank can lend out 90%, or $90, and must keep 10%, or $10, on reserve. What is important here is the assumption that the initial $100 deposit was first needed in order for the bank to make the loan - deposits create loans.

This $90 that the bank loans to someone else is now considered to be the new money created, because the first person who deposited $100 at the bank still has their $100 while the person who is borrowing the money now has $90. In total $190, which came from an initial $100. If this borrower takes the money and then deposits it into their bank account, the whole process can be repeated with a new borrower. This time $9 will be kept on reserve and only $81 can be loaned out.

As you can see, each time this process is repeated, the amount that can be loaned out becomes smaller and smaller. The total amount of new money that can be created from the initial $100 can be found using the inverse of the reserve ratio, (1/0.1), also known as the money multiplier. Multiplying the initial $100 by the multiplier and then subtracting that same initial amount will give you the total amount of new money created from that initial deposit.

That's it, $900 of new money, no more, no less. If banks want to loan out more money they either need to attract new deposits or wait for the central bank to provide them with more reserves. Banks can create a limited amount of new money, but being constrained by the reserve ratio, it is ultimately the central bank that controls the money supply through its increase or decrease of bank reserves. That's the fractional reserve banking model, which you can find in most standard macroeconomic textbooks. But that's not how the banking system actually functions.
The Hierarchy of Money
To see why, let's begin with a quote from Joseph Schumpeter's History of Economic Analysis, posthumously published in 1954. He writes, "It is much more realistic to say that the banks 'create credit,' that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them." While not word-for-word identical with the claims of our other two protagonists, the spirit is the same.

It is worth thinking about the differences. Notice that Schumpeter says that banks create "credit" rather than "money," the word used by both the Bank of England and Library of Parliament. He does, however, immediately replace the word credit with the word "deposit," bringing him closer to what we're familiar with. But which is it then? Are deposits best thought of as credit or as money?

It all depends on perspective. From the bank's perspective, that new deposit is a promise to pay something that we all would agree is unambiguously money - cash. Yet, because the deposit represents a promise to pay money, a kind of IOU, it seems like it would be best to refer to that deposit as credit rather than money.

That's the bank's perspective. From the depositor's perspective, because that deposit can be used to settle debts as well as purchase goods and services without having to convert to cash, it may as well be money. While the general public may not refer to the deposit itself as money (thinking of it more as some kind of container where their money is kept safe), this general public definitely refers to the balance of their deposit accounts as representative of their money. Again, it can be used to pay for things and settle debts. From the general public's perspective, it is money.

This dichotomy in perspectives lends credence to the idea that monetary systems are hierarchical. Within a country like Canada, the money issued by the Bank of Canada (i.e. cash and reserves) is at the top of that hierarchy. Bank deposits, which are issued by private banks, are lower on the hierarchy. IOUs that I issue to my friends and family are much much lower on the hierarchy. One could think of all money as a form of credit, although not all credit is considered money. It all depends on what level of the hierarchy you're situated.

This hierarchy of money is often masked by the fact that we use the word money to refer to both the stuff issued by the central bank as well as the stuff issued by private banks. Here's the Bank of England: " 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." By referring to both currency (i.e. cash notes and coins) and bank deposits as money, the Bank is recognizing the fact that for the general public, bank deposits purchase goods and services just as well as physical cash can. One could argue that deposits actually do these things better, since cash gets awkward (physically and socially) for large purchases.

Since deposits are better for making larger purchases, it would be reasonable to assume that most of the money in the economy comes in that form. That assumption would be correct, as the briefing from the Library of Parliament reads, "Most of the money in the economy is, in fact, created within the private banking system." The Bank of England is even more specific: "Of the two types of broad money, bank deposits make up the vast majority - 97% of the amount currently in circulation."
Banking in the Real World
As we turn to examining how private banks actually do create the majority of money in the economy, it's worth going through one more example of what banks do not do.

Suppose I lend $20 to a friend. I do this by giving my friend $20 in cash with the expectation that at some future date my friend will give me back $20. This is similar to what banks in the fractional reserve model do; although, if I were truly a bank and the $20 was all I had, then I could only lend out $18 and would have to keep the other $2 in reserve. But this is precisely what banks do not do. Banks do not lend out reserves or cash to their clients.

Rather, when a bank extends a loan, it simultaneously creates both an asset and a liability on its balance sheet. Here's an example of a simplified bank balance sheet to illustrate what I'm talking about.

There are a couple of important things to take note of here. First of all, notice that both sides of the balance sheet are equal: $110 on the liabilities side is matched by $110 on the asset side. Secondly, notice that reserves are exactly 10% of deposits, meaning that the regulatory reserve requirement is being met prior to the loan being made (even though I'm showing that the fractional reserve model is incorrect, banks still have to follow regulatory requirements).

Supposing the bank makes a loan for $20. That process is shown in the balance sheet below.

As you can see, the top portion of the balance sheet remains as before, but now, we see that the bank is adding $20 to both the asset side and liability side of its balance sheet to represent the process of extending a new loan. Notice that on the asset side we are recording a new loan, while on the liability side we are creating a new deposit, which of course is new money. Now we take a look at the balance sheet after the loan is made.

Notice that the balance sheet is still balanced. Also, notice that in extending the loan, the amount of reserves did not change. There was no draw down of reserves in order to make the loan. In other words, no reserves were lent out, as the fractional reserve model assumes. The bank simply created an asset and an offsetting liability, and that liability is a deposit, which is money, brand new money. That is what the Bank of England and Canada's Library of Parliament mean when they say that private banks create new money.

If I want to lend $20 to my friend following the logic of this banking model, I would have to write my friend an IOU worth $20. This IOU would be a promise to pay $20 in cash on demand. As you can see, this is where the hierarchy of money forcefully asserts itself. Unless my friend can use that $20 to buy goods and services and to settle debts, it will be little good to her. Bank IOUs (i.e. deposits) don't have that problem. That's the privilege that comes with being a bank.
Bank Lending is Not Reserve Constrained
There is one problem, however, with the above "Simplified Balance Sheet After the Loan is Made." Notice that reserves are now less than 10% of total deposits: 10/120 = 0.833 or 8.3%. Our bank is now in violation of a regulatory requirement, or at least it will be at the end of the day if it doesn't remedy the situation.

It's worth mentioning here that the above bank would not be in violation of any reserve requirement in Canada as well as several other countries. That's because the reserve requirement in these countries is 0%. That's right, there is no reserve requirement. The only limit to bank lending, if the fractional reserve model were correct, would be the total amount of reserves. Once a bank loaned out all the reserves, that's it, no more loans. But, as I have been arguing, that is not correct. Banks are not reserve constrained, regardless of whether there is or is not a reserve requirement.

The reason is simple: in monetary systems where central banks target the level of interest rates, they will supply whatever reserves are necessary to the banking system in order to maintain their interest rate target. We'll come back to this.

It may appear that our above example just couldn't happen in the real world because as soon as the bank makes that $20 loan, it is violating the reserve requirement. The bank would have to turn the customer away in order to avoid such a violation. However, banks never turn a customer away for this reason. They may turn them away for other reasons, but not because their reserves will fall below the legal minimum.

Banks make whatever loans they think are profitable and then look for the necessary reserves later. Here's Alan Holmes, a former senior vice president of the New York Federal Reserve Bank, stating in 1969, "in the real world banks extend credit, creating deposits in the process, and look for the reserves later." Then there's Vítor Constâncio, Vice-President of the European Central Bank, in a speech made in 2011, "In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money."

The above example of bank lending is actually quite accurate then. Banks make their loans first and then they search for the reserves, which they can find in the overnight interbank lending market. Banks with reserve deficiencies will borrow from banks with excess reserves. If a bank with a reserve deficiency cannot find a counterparty in the interbank market to lend them the reserves, they can always turn to the central bank's discount window.

If the banking system as a whole is running short on reserves due to increased lending activity, this will have upward pressure on the interbank interest rate, which is the central bank's key rate that it targets in conducting monetary policy. Because the central bank wants to maintain a specific level for that key rate, it will supply the necessary reserves demanded by the banking system in order to relieve the upward pressure (I told you we'd come back to this point). The central bank is reactive in its supply of reserves rather than proactive.

Confirming the fact that the reserve requirement does not constrain bank lending, as the fractional reserve model assumes, Claudio Borio and P. Disyatat from the Bank for International Settlements write in a 2009 paper, "the level of reserves hardly figures in banks' lending decisions," and that the central bank will supply whatever reserves are needed by banks: "in order to avoid extreme volatility in the interest rate, central banks supply reserves as demanded by the system " (emphasis theirs). If reserves are supplied on demand, then banks cannot be reserve constrained.
Final Remarks
Loans create deposits, which for banks, is a form of credit, and for the rest of the public, it's money. Banks create this money by simultaneously creating an asset and liability on their balance sheet, not by handing out cash or drawing down reserves. They create the loans first, then look for the necessary reserves later. The central bank supplies whatever reserves are necessary to the banking system in order to maintain its interest rate target.

Of course, the question of what does constrain bank lending and the total supply of money - if not the reserve requirement - is still open. That will have to wait for another post. In the meantime, hopefully parliamentarians will have a chance to catch up on their monetary education, if they haven't already.

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Apparently, a lot of people don't seem to know how money is created, and some of these are arguably people who should know. As much as 85% of British MPs were unaware that most of the money in the British economy is created by private banks, each and every time a loan is made, according to an article published by the Guardian just over a month ago.

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The Bank of Canada creates money through the buying up of the Government’s debt. This is not the only method of money generation. Private banks create money when issuing loans to individuals and businesses. This is often in the form of a mortgage, line of credit, or business loan. The borrowee creates a matching deposit in the borrower’s account which creates money. This is because Canada has a Fractional Reserve Banking system. When an entity deposits money into a bank, there’s a certain percentage which can be lent out to another entity. However, the balance of the account from the first entity remains the same.

I chose this article because is highlighted the fact that most people have no idea how money is created or lent. It also discusses the Fractional Reserve Banking System.

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Learning Objectives

By the end of this section, you will be able to:

Utilize the money multiplier formulate to determine how banks create money

Analyze and create T-account balance sheets

Evaluate the risks and benefits of money and banks

Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits. The T-account balance sheet for Singleton Bank, when it holds all of the deposits in its vaults, is shown in Figure 1. At this stage, Singleton Bank is simply storing money for depositors and is using these deposits to make loans. In this simplified example, Singleton Bank cannot earn any interest income from these loans and cannot pay its depositors an interest rate either.

Singleton Bank is required by the Federal Reserve to keep $1 million on reserve (10% of total deposits). It will loan out the remaining $9 million. By loaning out the $9 million and charging interest, it will be able to make interest payments to depositors and earn interest income for Singleton Bank (for now, we will keep it simple and not put interest income on the balance sheet). Instead of becoming just a storage place for deposits, Singleton Bank can become a financial intermediary between savers and borrowers.

This change in business plan alters Singleton Bank's balance sheet, as shown in Figure 2. Singleton's assets have changed; it now has $1 million in reserves and a loan to Hank's Auto Supply of $9 million. The bank still has $10 million in deposits.

Singleton Bank lends $9 million to Hank's Auto Supply. The bank records this loan by making an entry on the balance sheet to indicate that a loan has been made. This loan is an asset, because it will generate interest income for the bank. Of course, the loan officer is not going to let Hank walk out of the bank with $9 million in cash. The bank issues Hank's Auto Supply a cashier's check for the $9 million. Hank deposits the loan in his regular checking account with First National. The deposits at First National rise by $9 million and its reserves also rise by $9 million, as Figure 3 shows. First National must hold 10% of additional deposits as required reserves but is free to loan out the restFirst National Balance Sheet

Making loans that are deposited into a demand deposit account increases the M1 money supply. Remember the definition of M1 includes checkable (demand) deposits, which can be easily used as a medium of exchange to buy goods and services. Notice that the money supply is now $19 million: $10 million in deposits in Singleton bank and $9 million in deposits at First National. Obviously these deposits will be drawn down as Hank's Auto Supply writes checks to pay its bills. But the bigger picture is that a bank must hold enough money in reserves to meet its liabilities; the rest the bank loans out. In this example so far, bank lending has expanded the money supply by $9 million.

Now, First National must hold only 10% as required reserves ($900,000) but can lend out the other 90% ($8.1 million) in a loan to Jack's Chevy Dealership as shown in Figure 4.

If Jack's deposits the loan in its checking account at Second National, the money supply just increased by an additional $8.1 million, as Figure 5 shows.

How is this money creation possible? It is possible because there are multiple banks in the financial system, they are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply.

Watch this video to learn more about how banks create money.

In a system with multiple banks, the initial excess reserve amount that Singleton Bank decided to lend to Hank's Auto Supply was deposited into Frist National Bank, which is free to loan out $8.1 million. If all banks loan out their excess reserves, the money supply will expand. In a multi-bank system, the amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be "multiplied" as it is spent in the economy and then re-deposited in other banks.

Fortunately, a formula exists for calculating the total of these many rounds of lending in a banking system. The money multiplier formula is:

[latex]\frac{1}{Reserve\;Requirement}[/latex]

The money multiplier is then multiplied by the change in excess reserves to determine the total amount of M1 money supply created in the banking system. See the Work it Out feature to walk through the multiplier calculation.

Using the Money Multiplier Formula

Using the money multiplier for the example in this text:

Step 1. In the case of Singleton Bank, for whom the reserve requirement is 10% (or 0.10), the money multiplier is 1 divided by .10, which is equal to 10.

Step 2. We have identified that the excess reserves are $9 million, so, using the formula we can determine the total change in the M1 money supply:

Step 3. Thus, we can say that, in this example, the total quantity of money generated in this economy after all rounds of lending are completed will be $90 million.

The money multiplier will depend on the proportion of reserves that banks are required to hold by the Federal Reserve Bank. Additionally, a bank can also choose to hold extra reserves. Banks may decide to vary how much they hold in reserves for two reasons: macroeconomic conditions and government rules. When an economy is in recession, banks are likely to hold a higher proportion of reserves because they fear that loans are less likely to be repaid when the economy is slow. The Federal Reserve may also raise or lower the required reserves held by banks as a policy move to affect the quantity of money in an economy, as Monetary Policy and Bank Regulation will discuss.

The process of how banks create money shows how the quantity of money in an economy is closely linked to the quantity of lending or credit in the economy. Indeed, all of the money in the economy, except for the original reserves, is a result of bank loans that are re-deposited and loaned out, again, and again.

Finally, the money multiplier depends on people re-depositing the money that they receive in the banking system. If people instead store their cash in safe-deposit boxes or in shoeboxes hidden in their closets, then banks cannot recirculate the money in the form of loans. Indeed, central banks have an incentive to assure that bank deposits are safe because if people worry that they may lose their bank deposits, they may start holding more money in cash, instead of depositing it in banks, and the quantity of loans in an economy will decline. Low-income countries have what economists sometimes refer to as "mattress savings," or money that people are hiding in their homes because they do not trust banks. When mattress savings in an economy are substantial, banks cannot lend out those funds and the money multiplier cannot operate as effectively. The overall quantity of money and loans in such an economy will decline.

Watch a video of Jem Bendell discussing "The Money Myth."

Glossary

money multiplier formula

total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money

Solutions
Answers to Self-Check Questions

1. A borrower who has been late on a number of loan payments looks perhaps less likely to repay the loan, or to repay it on time, and so you would want to pay less for that loan.

2. If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it.

3. If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan.

4. If interest rates in the economy have fallen, then the loan is worth more.

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By the end of this section, you will be able to: Utilize the money multiplier formulate to determine how banks create money Analyze and create T-account balance sheets Evaluate the risks and benefits of money and banks Start with a hypothetical bank called Singleton Bank. The bank has $10 million in deposits.

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A bank has a certain quantity of assets, lets say currency, valued at X amount. The bank may be required to keep 1/10th of that value in reserve. However, the remaining 9/10ths may be loaned out to other entities (with interest) and earn returns for the bank, thus creating money. When that loan is cashed into another bank, the value of their assets increases by that amount, thus raising the amount which that bank can loan out and gain interest on. In countries with a multi-bank system, like Canada, this multiplies the money each time the money moves between banks. This is known as the Money Multiplier System. The way to calculate the number of times a loan will be multiplied as it is spent and deposited into other banks. The formula for this is (1/Reserve Requirement) or one over the reserve requirement.

I chose this article because it discusses multi-banking system and the money multiplier system. These are fundamental principles of money generation and build the foundation for how banks in Canada generate wealth.

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The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled.

- John Kenneth Galbraith, Economist

The Problem

If we ever hope to have a sustainable Canadian society we must change, among other things, a systemic flaw in our monetary system: the way we create and circulate money.

In Canada, a majority of the money in circulation has been created by private banks out of thin air as interest-bearing loans: money created as debt. ¹ In essence, we're borrowing from the future in the hope that continued economic growth will allow us to pay off this debt.

Canadian banks are part of the fractional reserve banking system. In fractional reserve banking, banks have to keep a certain amount of money (a fraction, say 10%) in the bank for every dollar they loan out. But in the 1990s, the reserve requirements in Canada were phased out and today there are none. Reserve requirements normally determine the money supply multiplier effect, which, in Canada's case, now appears to be infinite.

Money to pay the interest on the debt is not created at all and so must come from the money currently in circulation. But that money is already owed because it was created as debt.

Because more money needs to be paid back than was borrowed (principle plus interest), the total money supply has to continually increase to avoid loan defaults. That is, the amount of debt has to keep growing simply to put more money into circulation in order to cover the interest owed on past debts. Alternatively, some people must-and do-default on their loans.

When someone defaults on their loan, say a mortgage, the private bank will repossess the home. Thus, the bank ends up with real wealth-the house-for simply creating the initial money out of thin air. In other words, the private bank puts essentially nothing of its own assets on the line in the transaction but, in this case, ends up owning a real asset.

If the private banks stop giving out loans (i.e., stop putting more money into circulation), the system will collapse, thus the private banks have control over the money supply, not the people of Canada.

The amount of debt is always greater than the amount of money in circulation and thus can never be fully repaid.

Inflation is inherent in this money creation process as the money supply tends to increase faster than the amount of goods and services available. It is important to understand that this money supply is debt, not wealth.

Economic growth is inherent in this monetary system in order to ensure that interest on the debts can be paid, but never ending economic growth is impossible on a finite planet with finite resources (see Economic Growth).

When economic growth stops, due to outside factors such as peak oil, the system will begin to collapse.

The Solution

Once a nation parts with the control of its currency and credit, it matters not who makes the nations laws. Usury, once in control, will wreck any nation. Until the control of the issue of currency and credit is restored to government and recognized as its most sacred responsibility, all talk of the sovereignty of parliament and of democracy is idle and futile.

- William Lyon Mackenzie King, Prime Minister of Canada, 1935

The power to create money is, perhaps, the most important power of a sovereign nation. The following actions will help bring money creation back into the hands of an agency that acts in the interest of all Canadians, rather than the government being beholden to the private lenders as they are today.

Government borrowing from private lenders must be forbidden.²

The Government, through the Bank of Canada, rather than the private banks, must issue all the money and spend it into circulation free from debt.

Inflation would be prevented by tying government taxation and expenditure to the money creation. Remember, it's not who creates the money that causes inflation, it's how much is created and how it circulates.

The ability of the private banks to create money from thin air would be forbidden; the private banks must stop lending money they don't have.

Because banks can issue loans that are far in excess of their deposits (fractional reserve banking), they can create money. If they only made loans from their money already on deposit, no new money would be created.

Private banks would still be able to lend money but they would not be able to create money, they would lend only the money they have on deposit and they would be required to hold 100% reserves.

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¹ see How the Bank of Canada [and the private banks] Creates Money for the Federal Government: Operational and Legal Aspects. "... money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money. Most of the money in the economy is, in fact, created within the private banking system."
² Ideally, all government borrowing should be forbidden. If the government couldn't borrow monies, it would have to balance its budgets. Were the government to spent more than its income, politicians would feel immediate voter wrath because the government would have to immediately raise taxes to cover the deficit.
The imperative of perpetual growth implicit in interest is what drives the relentless conversion of life, world, and spirit into money.
- Charles Eisenstein

To understand more about this issue, see the sites and articles below, watch the videos and see also Canada's federal debt and Economic Growth on this web site.

Web sites and articles

Videos
Money as debt
Money Creation: The Crash Course
The Secret of OZ The crime of the Canadian Banking System

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Money creation The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple ... Continue reading →

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This article discusses some of the downsides of a Fractional Reserve System and how it can negatively impact the economy. The vast majority of money created by Canadian banks is created out of thin air as Interest Bearing Loans. Basically hoping that economic growth will allow us to pay off this debt in the future. The problem with this is that should there be a large economic downturn as the result of war, environmental changes, refugee crises, and global pandemics, we may not be able to pay off this debt. This requires the total supply of money to increase to pay the interest on past loans. When this gets out of control we see inflation. Inflation is when the Bank of Canada adds more currency into circulation. As more currency is added, the intrinsic value of each dollar becomes lower. When the economic growth runs out, or stalls, this inflation keeps the system from collapsing. The trouble begins when inflation outpaces the economic growth and wages do not rise as fast.

I chose this article because it is important to highlight some of the dangers of using a fractional reserve system. Especially nowadays when the fractional reserve system has essentially been phased out. This means that 100% of a deposit can be loaned with interest meaning that there may be no actual money in a bank, just debt to be repaid.

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How Banks Create Money and the Money Multiplier- Macro 4.8

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How Banks Create Money and the Money Multiplier- Macro 4.8

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Banks create money through the fractional reserve system. However, Canada does not strictly follow this system because up to 100% of their money can be loaned out. When an entity deposits the money into the bank, some or all of that money is then loaned out of other entities in the form of mortgages or business loans. These loans carry interest at a predetermined percentage, often depending on the amount or value of assets that entity has as collateral should they default on the loan. The loan will be spent and end up in another bank at some point in time. The bank will then repeat the process of taking the deposit, keeping a small reserve, and loaning the majority of it back out. This creates a problem when everyone wants to withdraw all their money from the bank at the same time. This is called a ‘bank run’ and is extremely bad. A good example of this was during the Great Depression when banks could only offer 5-10 cent returns per dollar to their customers.

I chose this video because it was very straight forward, simple and well researched. Although it did not have many of the nuances of the Canadian banking system it is still an excellent video to explain the basics.

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Banks create money by collecting deposits which allow them to create loans. When you place your money in a bank, they will earn you a small amount of interest at a predetermined amount. For most savings accounts this won’t be much more than a couple percent per year. The bank will then take your money and loan it to others at a much higher interest rate. That is the profit, and the interest you earn is the expense. Fractional reserves allows the bank to loan out a large fraction (or all) of your money to another entity whilst keeping your account at the same sum. For example, if you deposit $100, the bank can then loan out up to 100% out to another customer, creating up to $200. That other hundred dollars is NOT cash, and is debt owed to the bank. Banks will usually keep a small amount in reserve (5-10%) so that customers who want to withdraw money from their account may do so.

I chose this video because it explains more in-depth the concept of money multiplication and the broader impacts it has on national and international money markets.

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How Banks create Money out of nothing | The Hidden Secret - Part 1

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How Banks create Money out of nothing | The Hidden Secret - Part 1

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Banks often create 100x more money than one would expect. When banking was invented, people traded in gold and silver. These metals were very valuable and their value was well defined. As such, they were very useful as a means of currency. The first banks would offer to protect the gold of their customers for only a small fee, and the customer could withdraw as much money as they had in their account. Bankers began issuing fake receipts (especially to poor people) and charging interest on them. This is the genesis of modern banking.

I chose this video because it gave a basic introduction to the history of banking. This video also relates the process used in ancient times back to the modern day. This was a unique take on the banking system and shows that although there is much more nuance to banking today, the principles remain the same.

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Using the Bank of Canada to Create Money

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Using the Bank of Canada to Create Money

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The Bank of Canada buys Government of Canada bonds for cash. Those bonds are bought with interest and it pays dividends to the federal government. The money the government spends into circulation then ends up in private bands where the money multiplier system takes over and creates money based on debt owed. This allows the banks to increase their reserves which allows them to then lend more money to their customers.

The Bank of Canada has been responsible for Canada’s prosperity in large part because of its ability to regulate and stabilize our economy. In the first 35 years of its life, it helped us get out of the Great Depression and finance and fight World War 2. It also created capital to setup long term infrastructure projects which built much of the infrastructure we live and drive on today. However, in the 1970s, the system changed and subsequently the Government of Canada now often borrows directly from private banks and not from the Bank of Canada.

I chose this video because the topic of borrowing as debt has not been talked about very much. It is very interesting how this change occurred during a pivotal time in Canada and has been linked to much of the negative economic fallout since then. The misuse and poor utilization of the Bank of Canada serves as an important reminder of how powerful the banking lobby is in Canada.

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Money starts at the Bank of Canada as currency circulated into the nation’s economy. It is then deposited into private banks which loan most of the money back out to other customers. This creates new money equal to the value that was loaned and continues in a loop across many customers and many banks.

I chose this image because it shows the circular flow of money through the economy as it is traded for goods and services and loaned out to fund more goods and services.

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This image breaks down the money supply of a nation and how it breaks down into fractional reserves. The central bank prints a set amount of money into circulation and distributes it throughout the nation’s economy. The money then finds its way into smaller private banks. These smaller banks then loan out most of their reserves and charge interest on the loans. It is important to note that only a small percentage of a nation’s currency is in physical forms (coins and cash). The rest is contained as numbers in banks computers in the form of digital currency.

I chose this image because it does a good job of showing the entire money distribution within a nation.

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What did you learn about your topic that surprised you the most?

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What did you learn about your topic that surprised you the most?

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I learned a lot researching this topic. What surprised me however was how completely absent this information was in my schooling up to this point. It seems that the vast majority of Canadians are not adequately educated on how the monetary system works and how fragile it can be. One of the articles I read mentioned that 85% of British MPs have no idea where money comes from. It’s startling that there’s likely a very similar figure for Canadian MPs.

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This topic is relevant to me because I want to work in the government and find the concepts of currency and exchange very interesting. With my current interests in policing I could find myself investigating financial crimes relating to fraud, securities, and currency. Having a cursory knowledge of the basic money systems in Canada is hugely beneficial for that job.

Growing up I have always wondered how these institutions amassed such huge wealth and it seems like nobody wants to discuss how heavily these institutions are influencing our lives. I think every citizen has a responsibility to understand these concepts to better protect themselves.

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What knowledge would you pass onto a family member?

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What knowledge would you pass onto a family member?

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If I could, I would pass on the information surrounding the corruption in banking. After watching videos on how the Bank of Canada was blindsided by private banks, I am angry that there has been little effort to revert those changes. The Bank of Canada has a proven track record of protecting our economy and in the aftermath of COVID it would be very useful.

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This short presentation is designed to build a basic understanding for the process of money creation by banks in Canada. We will discuss private banks as well as the Bank of Canada. We will also touch on the process by which the government borrows money in exchange for securities. We will cover the basics of the Fractional Reserve Banking System and the Money Multiplier System.

Finally, we will discuss some of the history of banking and the history of the Bank of Canada.

I hope you enjoy!