Modern money has different forms
Physical notes and coins are only one part of modern money. People make most everyday payments using deposit balances recorded by commercial banks.
Central-bank money includes banknotes and the reserve balances commercial banks hold at the central bank. Commercial-bank money consists mainly of customer deposits.
A bank loan can create a new deposit
When a commercial bank approves a loan, it normally records a loan asset and credits a matching deposit to the borrower's account. The new deposit increases the amount of commercial-bank money available to spend.
The bank is not creating real goods or wealth. It is creating a financial asset for the borrower and a matching debt that must be repaid.
Repayment can remove deposit money
When the borrower repays loan principal, the bank reduces both the outstanding loan and deposit money used for repayment. In that sense, repayment can remove money previously created through lending.
Interest payments are treated differently from principal and contribute to the bank's income and expenses rather than simply reversing the original loan balance.
Banks cannot create money without limits
Banks must find creditworthy borrowers and manage capital, liquidity, funding, regulation and the risk that loans will not be repaid. Customers can also transfer deposits to other banks or convert them into cash.
Central-bank interest rates and other monetary-policy settings influence borrowing costs and credit conditions, affecting how much lending and deposit creation occurs.
Government spending is a separate process
Government spending, taxation and borrowing affect where money circulates and the demand for funds. The institutional process differs by country and should not be reduced to the claim that governments simply print every dollar they spend.
The important beginner distinction is between issuing central-bank money, creating commercial-bank deposits through lending and moving existing money between participants.
Visual recap
A simplified bank-loan cycle
The deposit and the debt are created together; repaying principal reverses that part of the balance-sheet expansion.
Bank approves loan
Loan asset recorded
Borrower deposit credited
Deposit can circulate
Principal repaid
Deposit money reduced
Key takeaways
- Most everyday money exists as commercial-bank deposits.
- Central-bank money and commercial-bank money are different liabilities.
- Bank lending can create a new deposit and a matching debt.
- Repaying principal can remove deposit money.
- Capital, liquidity, regulation, risk and demand limit bank lending.
- Creating money is not the same as creating real wealth.
Lesson recap
Check what you learned
Reveal each model answer, then honestly mark whether you understood it or need another review.
1 of 3
Recall
What normally happens to a bank's balance sheet when it makes a new loan?
References
