Credit Creation – The simple case.

Imagine there is only one bank in an economy. What happens to the amount of money in circulation if that bank receives a new deposit?

Banks need to satisfy two criteria:

1- Profitability

2- Liquidity

How do banks make profit? Well, they lend money out. They will then charge interest on those loans and make a profit.

Why keep money as cash deposits then? Well, they also need to keep money ready for their customers to withdraw it. This is the liquidity requirement. When I go to the ATM I want to be able to get my money out.

How much money should the bank keep liquid as cash deposits (sometimes called cash reserves) ready to give to their depositors and how much should it lend out to make profits? This will vary from bank to bank and will depend on business confidence, the state of the economy and any legal requirement.

How much money banks keep on reserves is called its liquidity ratio.

Impact and examples:

This liquidity ratio has a huge impact on the amount of money available in the economy. Let’s work through an example:

Assume a bank has $100 million as deposits. It decide it need to keep 10% as reserves. (That would be a liquidity ratio of 0.1.) So, $10 million stays in the bank and the other $90 million can be lent out in the pursuit of profits.

Now let us say the government decides to deposit $10 million at the bank. The bank now has $20million as cash deposits. It has also lent out, or advanced, another $90 million as loans. In total the bank now has $110 million. $20 million of this is now being held as cash deposits. (The original $10 million held back to meet its liquidity requirements and the additional $10 million recently deposited by the government.) However, it only needs to keep 10% of its money as cash deposits to meet its liquidity requirement. As a result of the new deposit it has surplus liquidity, 20/110 or 18.2% rather than 10%.

As a result of the surplus liquidity it can now lend more money. To get back to a 10% liquidity ratio they only need to keep $1 million and lend out the $9 million. (11/110 or 10%)

So the bank lends out $9 million. This money is spent with businesses. These businesses will then redeposit this money back at the bank. They have got the $9 million back! Again they are above their liquidity ratio of 10%.

So they repeat the process, again and again.

Eventually they return to a 10% liquidity ratio, but how much more money has been lent out?

The initial increase in deposits of $10 million will eventually lead to an increase in money supply of $100 million! How?

Well if the bank has to keep 10% of any deposits it has a liquidity ratio of 0.1. (1/10)

To work out how much a new deposit will increase money supply you simply work out the credit multiplier.

The credit multiplier is the inverse of the liquidity ratio. What does this mean? Well we worked out the liquidity ratio by dividing 1 by percentage of money we wanted to keep as cash deposits, 10%. 1 divided by 10 = 0.1 (1/10 = 0.1) The inverse of this is simple to divide 1 by 0.1 rather than by 10. (We have switched the 10 with the 0.1.) 1 divided by 0.1 = 10. Thus the multiplier is 10. 10 x $10 million = $100 million!

If the deposit had been $5 million and the liquidity ratio had been the same the multiplier would be the same and money supply would have increase by $50million (10 X $5 million = $50 million)

However if the bank loses confidence and worries that people may start taking out more of their money they may have to run a higher liquidity ratio, say 20% or 0.2. What would be the effect on money supply?

Well if the government again deposits $10 million, the new multiplier would be 1/0.2 = 5. 5 times $10million would be an increase of just $50 million dollars.

Application in the real world:

These changes in liquidity ratio have huge impacts on the economy. For example during the credit crisis banks started running much higher liquidity ratios. As a result the credit multipliers from deposits were far less. This meant less money was available to be lent out and business struggled to borrow.

Or, imagine the impacts of quantitative easing if banks suddenly lowered the liquidity ratio. A 5% fall in the banks liquidity ratio would double the multiplier and mean QE would be twice as effective in terms of increasing money supply. (What would be the consequence for inflation?) By contrast if liquidity ratios increased by 5% it would be half as effective, only half as much money will be supplied. (What would happen to interest rates and business access to credit?)

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