How do banks actually 'create' credit?

To illustrate how €1,000 of reserves can create €9,000 of deposits, we'll assume a reserve requirement of 10% and a single bank in the Eurozone.

Step-by-step illustration

• Initial Deposit: A customer deposits €1,000 into the bank.
• Reserve Requirement: The reserve requirement set by the European Central Bank (ECB) is 10% of total deposits.
• Excess Reserves: The bank must keep 10% of the initial deposit as reserves, which is €100 (10% of €1,000). This leaves the bank with €900 in excess reserves that can be used for lending.
• Credit Creation: The bank lends out the €900 to a borrower.
• New Deposit: The borrower receives the €900 loan, which is then deposited into another bank (possibly the same bank, but for the sake of simplicity, let's assume it's a different bank).
• New Reserve: The receiving bank must hold 10% of the new deposit as a reserve. Since the new deposit is €900, the reserve is €90 (10% of €900).
• Repeat: The process can continue as long as there are excess reserves. When the receiving bank lends the remaining €810 (€900 - €90) to another borrower, that amount becomes a new deposit, and the cycle continues.
• Click here to use my credit creation calculator.

To summarise the changes after each round of lending and deposit:

Round 1:

Initial Deposit: €1,000

Excess Reserves: €900 (€1,000 - €100)

New Loan: €900

Total Deposits: €1,900 (€1,000 + €900)

New Reserve: €190 (10% of €1,900)

Round 2:

New Deposit: €900 (from the loan in Round 1)

Excess Reserves: €810 (€900 - €90)

New Loan: €810

Total Deposits: €2,710 (€1,900 + €810)

New Reserve: €271 (10% of €2,710)

Round 3:

New Deposit: €810 (from the loan in Round 2)

Excess Reserves: €729 (€810 - €81)

New Loan: €729

Total Deposits: €3,439 (€2,710 + €729)

New Reserve: €344 (10% of €3,439)

This process can continue, and after several rounds, the deposits will reach approximately €9,000. As you can see, a single €1,000 deposit has resulted in a significant increase in total deposits through the creation of credit by the banking system. It's important to note that the process may not reach exactly €9,000 due to rounding and other factors, but this illustration demonstrates the idea of how banks can create credit and expand the money supply in the Eurozone.

Have a look at this short video on the concept.

The Gold Standard and Its Abandonment: Facilitating Credit and the Rise of Fiat Money

The Gold Standard was a monetary system in which a country's currency was directly linked to a specific amount of gold. Under this system, governments would hold gold reserves equivalent to the value of their circulating currency. This linkage ensured that the value of the currency was stable, as the amount of money in circulation was tied to the available gold reserves.

Mechanics and Benefits of the Gold Standard:

• Fixed Exchange Rates: With the Gold Standard, exchange rates between different countries were relatively stable, as the value of each nation's currency was determined by its gold reserves. This stability encouraged international trade and investment, as businesses and individuals could make transactions with confidence.
• Inflation Control: As the money supply was directly tied to the gold reserves, it curtailed excessive money printing by governments, which helped control inflationary pressures. The limited money supply acted as a natural restraint on the expansion of credit and debt.
• Credibility and Trust: The Gold Standard instilled confidence in the monetary system, as the convertibility of paper currency into gold assured individuals that their money had intrinsic value. This credibility fostered trust between citizens and the government, which was crucial for economic stability.

Abandonment of the Gold Standard: Facilitating Credit Creation:

Despite its advantages, the Gold Standard had limitations, particularly during times of economic crisis and growth, e.g. the Great Depression of the 1930's. One of the significant drawbacks was the inability to provide sufficient liquidity during periods of financial stress. As economies expanded, the fixed supply of gold hindered the ability to create credit to meet the demands of a growing economy.

To address these limitations and facilitate credit creation, governments began transitioning away from the Gold Standard and adopted fiat money. Fiat money is currency that has no intrinsic value and is not backed by a physical commodity like gold. Instead, its value is derived from the trust and confidence that people have in the issuing government and its economy.

Benefits of Fiat Money:

• Flexibility: Fiat money allows central banks and governments to adjust the money supply based on economic conditions. During recessions or periods of low growth, they can increase the money supply to stimulate the economy and promote credit creation.
• Liquidity Provision: Unlike the Gold Standard, where the money supply was limited by available gold reserves, fiat money permits the expansion of credit as needed, helping address liquidity shortages and stabilise financial markets during crises.
• Economic Growth: The flexibility of fiat money enables governments to implement monetary policies that encourage investment, consumption, and overall economic growth.

The Gold Standard served as a strong foundation for the global economy by providing stability, fixed exchange rates, and inflation control. However, its limitations in facilitating credit creation and providing liquidity during economic expansions led to its abandonment in favour of fiat money. The adoption of fiat money allowed central banks and governments to have greater control over monetary policy, enabling them to respond more effectively to economic challenges and opportunities. Nonetheless, the shift from the Gold Standard to fiat money also introduced new challenges, such as the need for responsible monetary management to prevent excessive inflation and maintain economic stability.