How do banks create money? Out of thin air

Banks create money by fractional reserve banking. This is my simple explanation.

6 minute read

Understanding how money is created, by both banks and governments, and then distributed into the economy are key areas to have an understanding of if you wish to become successful at trading in the foreign exchange markets. Traders are obsessed with money (at least I certainly am, you?) and it’s useful to know how banks create it. Fractional reserve banking is the form of banking which most countries throughout the world use today, and it is one which has been in place since at least the 13th century, and quite possibly much earlier than that.

How do Banks Create Money
For every $10 a customer deposits into their bank account, the fractional reserve banking system (that nearly every bank in the world uses) will result in a further $90 being loaned out to debtors and going into circulation within the economy.

Whilst is sounds a complicated term, the premise for this system is actually fairly basic. It centers on the fact that banks are only required to hold a fraction of their deposit liabilities, which is usually 10% (the Federal Reserve, or Central Banks set this requirement). To put this in layman terms, if Miss Taranova (that’s me!) deposits $100 into the bank, that bank need only hold $10 of my capital in their reserves. The remaining $90 they are free to loan out to another individual; so we have a situation where an extra $90 has been put into circulation seemingly out of thin air. It is ‘in’ circulation because of the $90 loaned out, alongside the fact that Miss Taranova still has full access to the $100 she deposited, as she can go to the bank at any time to withdraw this sum (unless there is a run on the banks, in which case I’m screwed because I hate queues!).

 

The individual who was loaned the $90 can then put this capital into their own bank, and the process can repeat itself so that even more money is put into circulation. At a 10% reserve rate, we eventually end up with $1,000 in circulation from Miss Taranova’s original $100 deposit. The banks rely on the fact that not all of their depositors will want to withdraw their money simultaneously, indeed, if there were an economic event which caused widespread panic and this action ensued, it would result in what is known as a bank run. Governments might step in and offer security if this happens, but be forewarned there is no legal obligation for them to do this. This is why doomsday preppers and conspiracy theorists still keep their money under their mattress, I would do the same but I have a bad back and personally don’t want to sleep 2 inches from the ceiling ;p)

 

A bank run is a scenario which involves the general public withdrawing a large percentage of their capital from high street banks, and it’s very likely that economic events which cause a run on the high-street banks in the first place will also result in a sharp downward trend in that country’s currency value in the foreign exchange markets. This is an extreme example to show how negative economic news or a black swan event can cause a sell-off. Movements in currency markets are generally more subtle and are guided by monthly data sets released by governments, which include statistics such as gross domestic product (GDP) and unemployment rates. Positive figures generally result in an upward move in the exchange rate and vice-versa.

 

Knowing what causes capital to move around within the markets and where it is likely to be re-invested is extremely advantageous, but it is worth noting that there is often more than two ways a situation can play out, and looking for tell-tale signs in the markets to see which play is likeliest is a skill that even the most professional traders don’t get right every time (I get it right most of the time, just saying).

"Correlations don’t always work and it’s important to wait for confirmation before you trade; just because investors pulled their money out of the dollar doesn’t guarantee that they will re-invest it into gold."

The Federal Reserve and Central Banks can adjust the reserve requirement the banks are ordered to hold as a way of controlling the money supply within the economy, at source, if you will. However, they tend to keep a lever on this supply from the capital end as it goes out, as opposed to when it comes in, and they do this by setting interest rates on the monies the banks are loaning. They know quite simply, that higher interest rates will result in less individuals borrowing, and therefore less money circulating in the economy (boo-fucking-hoo, what will ever happen to the mass produced crap stores want the sheeple to buy if there is no money, huh?).

 

This information can be used to aid you in trading the Forex markets since it is evident that interest rate policies have a huge bearing on the value of a country’s currency and what direction the exchange rate is headed. Namely in the fact that the higher a country’s interest rates are, the more investors will want to deposit their money in that country’s banks, which in-turn will raise the value of its currency. Interest rate policies are of course a giant puzzle which investors are constantly attempting to make sense of, and are determined by a range of economic indicators.

 

If you take logical steps you would assume that the higher a country’s population, the more demand there would be for that particular currency, and so in theory it should be worth more. This is not necessarily the case though, since demand for a currency is not made up solely from its inhabitants; there are also businesses and banks which account for a large percentage. The reason as to why these institutions would invest into a particular country are factors such as strong and consistent economic statistics such as GDP and CPI figures. It may also be that a country is considered an emerging market, and they might have a natural resource (please be diamonds… please be diamonds) or particular industry which is experiencing a strong growth phase, which in-turn, is tempting individuals to invest their capital with large risk versus reward ratios.

 

The foreign exchange markets are highly complex instruments, and it takes a talented individual to put all of the pieces together and profit from them (it also helps if you have an awesome teacher, right?). These markets are highly liquid and offer the retail trader with abundant opportunities; take the time to research first, and then make considerable room in your portfolio to trade these products.

 

Good lesson, let’s move on.

 

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