How do banks create this invisible money? Let’s take a simple look at the process of how money is created through the nature of money, credit, and the role of the reserve requirement ratio.

Money is credit!

Why does the money supply need to grow? And “how” can the money supply actually increase? To unravel this mystery, we need to examine “deposits and loans”—something everyone has experienced at least once. We often assume that when we make a deposit, the bank is simply “holding” our money. And when we take out a loan, we think the bank is “lending” us money that was sitting in its vault—that is, money someone else deposited there. And the truth is, this way of thinking is taken for granted. However, this is nothing more than a misconception stemming from our lack of understanding about banks.
We often say, “Money is printed by the Mint,” but the physical money we actually handle is only a tiny fraction of the total money supply. The rest is money we cannot touch—virtual money that exists only as numbers. Let’s hear what the experts have to say.

Niall Ferguson, Professor of History at Harvard University

“When people talk about money, most picture something like a $5 bill. They imagine only things like paper bills or coins. Of course, those are part of money. But the truth is, most money is invisible.”

Ellen Brown, Executive Director of the Institute for Public Banking and attorney

“People look at the government’s printing presses and think the government creates money. But that’s not how money is created.”

This Is How Money Is Created

So how exactly is money created? The secret lies in the process by which banks accept deposits and make loans.
For example, let’s say you put $100 in a safe at home. No matter how much time passes, that $100 will simply remain $100. But suppose you deposit that money in a bank. The bank doesn’t just leave that money sitting there. When the bank receives $100, it keeps only $10 and lends the remaining $90 to a person named A. As a result, not only is $100 already credited to my account, but $90 is also credited to A’s loan account. Now that Person A can also spend $90, the total amount of money that Person A and I can spend simultaneously suddenly becomes $190. As a result, through the process of lending, the original $100 deposit has created $90 in new money. This $90 that appeared out of nowhere is called “credit money.”

If I deposit the $100 I had in my safe into the bank, the bank keeps $10 and lends the rest to Person A. Now, Person A and I can withdraw and spend a combined total of $190.

How is this possible? It’s all because of a promise. This is possible because the government has permitted banks to lend out $90 of every $100 in deposits, retaining only 10%. Furthermore, this permission and promise are outlined in ‘Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion’, an operational manual published in 1963 by the Federal Reserve Board (FRB). According to this regulation, banks must keep 10% of the money on hand as a “fractional reserve ratio.” This refers to “the percentage of money a bank must set aside in case customers withdraw their deposits.” This is simply called the “reserve ratio.” The fact that there is more money in circulation than the actual amount of money in existence is due to this “reserve ratio.” This is according to Professor Jeffrey Myron of the Department of Economics at Harvard University.

“Most of the money deposited in banks does not actually exist there. It has all been lent out. The reserve ratio kept at banks is typically around 10%. If you deposit $1,000 into an account, $100 is kept by the bank, and $900 is lent out as mortgages, car loans, business loans, and so on.”

The money we deposit in banks is never actually “held” by the bank. It’s merely a number reflecting that amount on my account statement, while the remaining 90% is lent out to others. Conversely, the same applies if I take out a loan. The point is that banks do not lend me a portion of the money they’ve received from others; rather, they “create” money by crediting 90% of the deposited amount to my account via their computer system. Ultimately, the bank’s role is not simply to hold money and lend it out as-is to earn a profit. The essence of what banks do can be described as “creating money out of thin air.”

The money supply expands according to the reserve requirement ratio

So, just how much can the money supply actually grow? Let’s assume, for example, that $10 billion has been deposited. If the government sets the reserve requirement ratio at 10%, the bank keeps 10% of that $10 billion—$1 billion—and lends the remaining $9 billion to another bank, Bank B. Bank B can then set aside 10%—$900 million—and lend the remaining $8.1 billion to Bank C. Bank C can then set aside 10% of that amount and lend the rest to Bank D; Bank D can then lend to Bank E; and Bank E can then lend to Bank F, and so on. As a result, when added to the original $10 billion, the total becomes $10 billion + $9 billion + $8.1 billion + $7.2 billion + $6.5 billion + $5.9 billion + …—a staggering $100 billion in new money is “created.” Ultimately, money is not something we exchange with one another, but rather a product created by banks. We refer to this process of creating money that doesn’t actually exist and intentionally increasing its supply as “credit creation” or “credit expansion.”
In fact, when you think about it, the process of creating new money is actually quite simple. Banks need only retain an amount equal to the reserve requirement ratio of the money received and then simply “type” numbers into the borrower’s collateralized deposit account. Neil Ferguson, a professor of history at Harvard University, puts it this way:

“We think money is in the bank because we can withdraw it immediately from an ATM. But in reality, it’s only there in theory. Money is almost invisible; it appears only as numbers entered on a computer screen.”

Let’s hear from Jeffrey Ingham, a professor of sociology at the University of Cambridge in the UK.

“It’s a promise to pay. It’s credit. All money is credit.”

The graphs showing the growth in the money supply and the rise in prices are almost identical. This clearly demonstrates the correlation between the money supply and prices. We refer to this economic phenomenon—where an increase in the money supply causes the value of money to fall and prices to rise—as monetary expansion, or inflation.
Ultimately, it would be more accurate to describe the capitalist economic system not as a “society driven by money” but as a “society that creates money.” And at the very heart of building such a society lies the institution known as the “bank.” It is because banks exist that the money supply increases, and consequently, prices rise.
We often say that rising prices are due to economic difficulties. Furthermore, many companies, when raising their prices, claim, “We have no choice but to raise prices because raw material costs have gone up.” However, this is merely a superficial explanation. The rise in raw material prices is also caused by the increase in the money supply. The fundamental cause of rising prices is neither increased consumption nor companies seeking to maximize profits. It is, in fact, the banks themselves—and the capitalist system that revolves around them.