Most of the money people use every day is not paper cash or coins. It is bank deposits, the numbers shown in checking and savings accounts. Commercial banks create these deposits when they make loans to households and businesses.
This matters because lending affects spending, jobs, prices, and personal borrowing decisions.
When a bank approves a loan, it usually does not hand over existing cash from a vault. It creates a new deposit in the borrower’s account, which becomes money the borrower can spend. As borrowers repay loans, the deposit money created by the loan is reduced or destroyed.
Banks are limited by regulations, reserves, capital, borrower demand, and the need to stay profitable and safe.
Key Facts
- Bank lending creates new deposits, and deposits are part of the money supply.
- New loan made by a bank: bank asset increases by the loan amount, and bank liability increases by the new deposit.
- Loan repayment reduces money in circulation because the borrower’s deposit is used to cancel the loan principal.
- Money supply change from one loan and repayment: ΔMoney = new loans minus principal repayments.
- Banks do not simply lend out the exact same deposits one at a time, but they must manage reserves, capital, risk, and payment flows.
- Example: If a bank makes a 10,000, so the money supply increases by $10,000 at that moment.
Vocabulary
- Commercial bank
- A financial institution that accepts deposits, makes loans, and provides payment services to households and businesses.
- Bank deposit
- Money recorded in a bank account that the account holder can use to make payments or withdraw cash.
- Money supply
- The total amount of money available in an economy, including cash and many types of bank deposits.
- Loan principal
- The original amount borrowed that must be repaid, not including interest.
- Reserves
- Funds that banks hold as cash or as balances at the central bank to settle payments and meet withdrawal needs.
Common Mistakes to Avoid
- Thinking banks can create unlimited money, which is wrong because banks face capital rules, reserve needs, risk controls, borrower demand, and repayment limits.
- Saying banks only lend out money that savers already deposited, which is incomplete because a new bank loan creates a new deposit at the same time.
- Counting loan interest as newly created principal money, which is wrong because interest is income paid to the bank while the loan principal is the part that created the original deposit.
- Forgetting that repayment destroys deposit money, which is wrong because paying down principal cancels part of the bank’s loan asset and removes spending money from the borrower’s account.
Practice Questions
- 1 A bank approves a $5,000 student loan and credits the borrower’s checking account. By how much does the money supply change at the moment the loan is created, assuming no other changes?
- 2 During one week, a bank makes 35,000 in principal repayments. What is the net change in deposit money from these loan activities?
- 3 Explain why a bank creating a deposit through a loan is different from a government printing paper currency, even though both can increase the money people use.