Please let me know if I have understood the concept correctly and completely.
A commercial bank is required to keep only a fraction, let us say 10%, of its reserves for demand deposits at any one time.So for instance if a deposit of $10,000 is made then a $90,000 dollar loan can be extended based on $10,000 of reserves. The bank simply does this by “creating” the electronic (not FRNs) money and crediting to the account holder to whom the loan is being extended.
I understand the above (let me know if there is anything incorrect), what comes next confuses me. If the $90,00 loan is used by the account holder to purchase a home those $90,000 dollars are then given to another individual who deposits that money at his or her bank. Let us say that in the worst case scenario the individual does not pay any of the $90,000 loan back and thus the bank must now foreclose on the property. The bank then manages to sell the property, but at a reduced price of $45,000.
So to summarize:
$10,000 deposit (made by Joe) which remains as reserves at the Fed
$90,000 loan created by the bank and credited to Jane
Foreclosure and sale of the property for $45,000
Now the bank has $45,000 dollars.
Does the $90,000 have to be paid back to anyone or anything? Is this money that is “created out of thin air” actually borrowed from the Fed and thus must be paid back plus interest? So really the bank has taken a significant loss? If that is not the case the bank has still gained $45,000.
For the first part, I think you got it wrong. If the bank with 10% reserves recieves a 10k deposit, they can give out 9k of that in the form of loans, investment, etc.
For the second part, when the bank loaned 90k, but only got back 45k, the bank is in trouble, since they basically lost 45k in their assets. The bank must find some way to make up for this loss.
If a deposit of $10,000 is made, the bank can then turn around and loan $9,000 out, not $90,000. However, the total amount of money created in the entire system from the initial $10,000 deposit is $90,000 because once that $9k loan is deposited in another bank, that second bank will turn around and loan approximately $8.1k (90% of 9k). The next bank to receive the $8.1k will then turn around and lend 90% of that sum. This cycle continues until a total of $90k has been created from the initial $10k deposit.
Yes, now I see. But, in fact, the amount of credit created will never even reach 90k, right?
If you deposited Y the bank is able to loan 0.9Y. Then the borrower would deposit this amount in other bank, which, in turn, would be able to loan 0.9 x 0.9Y = 0.81Y. Another bank would loan 90% of this amount: 0.9x0.81Y = 0.729Y. Then another bank would, again, loan 90% of this: 0.9x0.729Y = 0.6561Y. And so on.
0.9Y + 0.81Y + 0.729Y + 0.6561Y… will never equals 9Y.
That’s correct. Like a limit in calculus. As the number of iterations approaches infinity, the sum of cash created from the initial 10k deposit approaches 90k.
Thank you for the reply, but did the bank borrow the money from the FED and thus has to repay the FED ultimately?
I guess my question ultimately is: “Under the fractional reserves system, does a bank can merely conjure up 90% of the loan’s value by borrowing this amount from the FED who “prints” the money?”
Yes, the bank has to repay the loan. However, central banks almost never suck liquidity. As loans are repaid, new are made, usually in greater amount. [;)]
It’s the official policy, “pump it up”. CB does not usually target monetary aggregates, it targets interest rate.
of course if the banks find that demand for cash is outsrtripping their ability to supply (given the multiplication of money by frb, meaning that depositors have ‘rights’ to withdraw out of their deposit accounts way more cash then was originally produced by the treasury) a bailout and the printing presses are only a phonecall away.
Shhh. You sound as if disagreeing with scineram and his brilliant and enlightening newfound wisdom on the true nature of frb. Frb is a flawless creation of the market which benefits both counterf…I mean bankers and their customers. Don’t you know that ‘free’ banking in scotland blah blah blah…