Money Created by Banks

For all of you who have been watching the Paul Grignon videos here is a little something about money created by banks.

The basic text book view is that commercial banks create  money through fractional-reserve banking,i.e. the banking practice where banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.Commercial bank money is non-physical, as its existence is only reflected in the account ledgers of banks and other financial institutions.Also there is some element of risk that the claim will not be fulfilled if the financial institution becomes insolvent.So central banks make deposit insurance mandatory for banks.

Because of the prevalence of fractional reserve banking, the broad money supply of countries is a multiple larger than the amount of base money created by the country’s central bank. That multiple (called the money multiplier) is determined by the reserve requirement or other financial ratio requirements imposed by financial regulators.

However vis-a-vis this mainstream economic belief, a number of central bankers, monetary economists, and text books, have said that banks create money by ‘extending credit’, where banks obligate themselves to borrowers, and then later manage whatever liabilities this creates for them, where if the central bank targets interest rates, it must supply base money on demand to meet the banks reserve requirements, after the banks have begun the lending process and that rather than deposits leading to loans, causality is reversed, and loans lead to deposits.This point of view is explained by Prof.Richard Werner in this video: