Credit Creation and the Money Market
Aoife's parents are buying a house in Sligo and the bank has approved a mortgage of €280,000. The bank does not have a vault full of €280,000 that belongs to the bank. So where does the money come from? And if thousands of families get loans like this at the same time, what happens to the amount of money in the economy? By the end of this page you will be able to answer both questions.
Who does what in the Irish financial system
Four types of institution matter for this topic. Each has a different job.
| Institution | Main role |
|---|---|
| European Central Bank (ECB) | Runs monetary policy for the whole euro area: sets the key interest rates and aims for inflation of about 2% over the medium term. |
| Central Bank of Ireland | Part of the Eurosystem. Supervises and regulates Irish banks and other financial firms, protects financial stability and sets rules such as limits on mortgage lending. |
| Commercial banks | Accept deposits, make loans and provide payment services. They are the institutions that create credit. |
| Credit unions | Member-owned, not-for-profit co-operatives. They take savings from members and lend mainly to members, usually small personal loans. |
Name the main role of each of the following in the Irish financial system: a) Central Bank of Ireland b) The European Central Bank c) Commercial banks d) Credit unions
Name the main role of each of the following in the Irish financial system:
- a) Central Bank of Ireland
- b) The European Central Bank
- c) Commercial banks
- d) Credit unions
How banks create credit
Banks take in deposits and lend most of them out. They earn income from the difference between the interest they charge on loans and the interest they pay on deposits.
They cannot lend out everything, because depositors need to withdraw cash on any given day. So banks keep a fraction of deposits as reserves (cash and balances at the central bank). In our model, the minimum fraction is set by the required reserve ratio, $r$.
Most depositors do not all withdraw at once, so a bank can lend out the rest and still meet normal withdrawals. If everyone did try to withdraw at once (a bank run), the bank could not pay.
When the bank lends €9,000, the borrower gets a new deposit of €9,000 in an account. The loan did not take money from anyone else's account. A new deposit has appeared, so the money supply has grown. That is what "creating credit" means.
A bank's actual reserve ratio can be higher than the required one. Reserves above the minimum are excess reserves. Banks may choose to hold them as a safety cushion (uncertain times, fear of withdrawals) or because few good borrowers are available.
A commercial bank receives a deposit of €10,000 and must hold a required reserve ratio of 10%. a) Calculate the reserves the bank must keep. b) Calculate the maximum…
A commercial bank receives a deposit of €10,000 and must hold a required reserve ratio of 10%.
- a) Calculate the reserves the bank must keep.
- b) Calculate the maximum amount the bank can lend out from this deposit.
- c) Explain why banks do not keep all deposits as cash.
A bank has deposits of €400 million, reserves of €60 million and loans of €340 million. a) Calculate the actual reserve ratio. b) If the required reserve ratio is 10%,…
A bank has deposits of €400 million, reserves of €60 million and loans of €340 million.
- a) Calculate the actual reserve ratio.
- b) If the required reserve ratio is 10%, calculate the excess reserves and the potential additional lending by this bank alone.
- c) Explain why a bank might choose to hold more reserves than required.
The money multiplier
The borrower from the last section spends the €9,000, for example paying a builder. The builder lodges it in a bank (the same bank or another). That bank keeps 10% and lends out 90%, and the process repeats.
| Round | New deposit | Reserve kept (10%) | New loan |
|---|---|---|---|
| 1 | €10,000 | €1,000 | €9,000 |
| 2 | €9,000 | €900 | €8,100 |
| 3 | €8,100 | €810 | €7,290 |
| 4 | €7,290 | €729 | €6,561 |
| … | … | … | … |
| Total | €100,000 | €10,000 | €90,000 |
Each round is 90% of the one before, so the total follows a geometric series with sum $\frac{10{,}000}{1 - 0.9} = 100{,}000$. This gives a simple rule.
Why does it work? Each €1 of reserves can support €$\frac{1}{r}$ of deposits. When $r = 10\%$, €1 of reserves supports €10 of deposits.
Use the graph to see how the multiplier changes as the reserve ratio rises. The horizontal axis is $r$ in per cent.
Why the real multiplier is smaller
The simple formula gives a maximum. In reality:
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People hold cash. Some of every new payment stays as cash in wallets and is never deposited. This is a cash drain. The cash ratio $c$ is the share of new money held as cash.
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Banks hold excess reserves, so not all possible lending takes place.
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Not enough borrowers. Loans only happen if households and firms want to borrow, which depends on the interest rate and on confidence.
Including cash, the multiplier becomes
$$\frac{1}{r + c - rc}$$where $r$ is the reserve ratio and $c$ the cash ratio. You will always get a smaller value than $\frac{1}{r}$ when $c > 0$.
Calculate the money multiplier when the reserve ratio is: a) 10% b) 20% c) 5% d) Explain what happens to the multiplier as the reserve ratio rises.
Calculate the money multiplier when the reserve ratio is:
- a) 10%
- b) 20%
- c) 5%
- d) Explain what happens to the multiplier as the reserve ratio rises.
A new cash deposit of €50,000 is made in a bank in Sligo. The reserve ratio is 8%. Assume that all loans are re-deposited in the banking system and no cash is held…
A new cash deposit of €50,000 is made in a bank in Sligo. The reserve ratio is 8%. Assume that all loans are re-deposited in the banking system and no cash is held outside banks.
- a) Calculate the maximum total increase in deposits.
- b) Calculate the total amount of new loans created.
- c) Explain two reasons why the actual increase would be smaller than your result.
The reserve ratio is 12.5%. The banking system receives an injection of €80 million of new reserves from the central bank. a) Calculate the money multiplier and the…
The reserve ratio is 12.5%. The banking system receives an injection of €80 million of new reserves from the central bank.
- a) Calculate the money multiplier and the maximum increase in deposits.
- b) If the public holds 20% of any new money as cash outside the banks and banks hold 12.5% as reserves, calculate the revised multiplier using $\frac{1}{r + c - rc}$ where $r$ is the reserve ratio and $c$ is the cash ratio, and the resulting increase in money supply.
- c) Explain why central banks cannot control the money supply exactly.
- d) Discuss how the ECB's interest rate decisions affect Irish credit conditions.
The money market and the interest rate
The money market is where the demand for money (including credit) meets the supply of money. The price of money is the interest rate.
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Demand for money slopes downwards. A higher interest rate raises the cost of borrowing and the opportunity cost of holding cash instead of an interest-earning asset, so people and firms want to hold and borrow less.
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Supply of money is set by the central bank and the banking system. We draw it as a vertical line because it does not depend on the rate in this model.
At equilibrium, the quantity of money demanded equals the supply.
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Interest rate above equilibrium: the supply of money exceeds demand. Banks have more funds than people want to borrow, so rates are pushed down.
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Interest rate below equilibrium: demand exceeds supply. There is excess demand for money and rates are bid up.
When the supply of money rises, the interest rate falls, borrowing, investment (and consumer spending on credit) increase and aggregate demand rises. When the supply falls the opposite happens.
We can also solve a linear money market algebraically. Suppose $M_d = 1{,}000 - 100i$ and the supply is fixed at €600 million. In equilibrium:
$$1{,}000 - 100i = 600 \Rightarrow 100i = 400 \Rightarrow i = 4\%$$If the supply falls to €500 million, then $1{,}000 - 100i = 500$, so $i = 5\%$.
In a money market the demand for money is shown below at different interest rates, with the supply fixed by the central bank at €500 million. | Interest rate (%) | Money…
In a money market the demand for money is shown below at different interest rates, with the supply fixed by the central bank at €500 million.
| Interest rate (%) | Money demanded (€m) |
|---|---|
| 1 | 700 |
| 2 | 600 |
| 3 | 500 |
| 4 | 400 |
| 5 | 300 |
- a) Identify the equilibrium interest rate.
- b) Describe what happens at an interest rate of 2% and explain how the market adjusts.
- c) The central bank raises the supply of money to €600 million. State the new equilibrium rate and explain the effect on borrowing and spending.
The demand for money in an economy is $M_d = 1,000 - 100i$ where $i$ is the interest rate in per cent and $M_d$ is in €million. The supply is fixed at €600 million. a)…
The demand for money in an economy is $M_d = 1,000 - 100i$ where $i$ is the interest rate in per cent and $M_d$ is in €million. The supply is fixed at €600 million.
- a) Calculate the equilibrium interest rate.
- b) The central bank reduces supply to €500 million. Calculate the new equilibrium rate.
- c) Explain the effect of this change on investment, consumption and aggregate demand.
- d) Discuss why a small euro area economy like Ireland cannot set its own interest rate and the implications for stabilising its economy.
Credit, the crisis and regulation
Credit creation is useful: it finances houses, businesses and investment. But too much credit, lent too freely, causes trouble. Ireland shows how.
The credit boom. In the years up to 2008, Irish banks lent rapidly, especially for property. Each loan created new deposits, so the money supply grew. More money chasing a limited number of houses pushed property prices up. Rising prices made people think prices would keep rising, so they borrowed even more, and rising spending put upward pressure on inflation, particularly in construction and services.
The bust. When property prices fell, the value of the assets held by banks and borrowers dropped. Many borrowers could not repay loans. Banks' losses reduced their capital (the buffer between assets and liabilities), so they cut lending (a credit crunch). Firms could not borrow, investment and spending fell, and unemployment rose. The government guaranteed bank liabilities in 2008, and the cost of rescuing the banks added heavily to the national debt, leading to the EU–IMF programme of 2010–2013.
Regulation. Today two bodies share responsibility:
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The ECB sets euro area interest rates and supervises the largest banks (the Single Supervisory Mechanism).
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The Central Bank of Ireland supervises Irish banks, sets capital requirements (banks must hold more of their own funds relative to loans) and, since 2015, has used mortgage lending rules that limit loan-to-income and loan-to-value ratios. These make a repeat of reckless property lending less likely. Credit unions are also regulated by the Central Bank of Ireland, which sets rules on their lending and reserves to protect members' savings.
Saving and investment are linked to the interest rate through the banks: savers' deposits give banks funds to lend, so a rise in saving increases the supply of credit funds and puts downward pressure on rates, while a rise in firms' demand for investment loans pushes rates up.
What drives the demand for and supply of credit funds
Demand for credit funds comes from households (mortgages, car loans), firms (investment) and the government (borrowing to cover a budget deficit). It rises when incomes and confidence are high, when expected profits are high, or when the government borrows more. It falls when people expect a downturn.
Supply of credit funds comes from savers' deposits, from the banks' own lending capacity (their reserves and capital), and from the central bank. It rises when saving rises, when banks have more excess reserves, or when the ECB increases liquidity. It falls when banks are cautious or capital rules tighten.
Effects on economic activity. Saving is a leakage from the circular flow of income: money saved is not spent. Investment is an injection: borrowed funds spent on capital goods add to spending. Banks link the two by turning savings into loans. A lower interest rate raises investment and consumer borrowing, so injections grow, aggregate demand and national income rise (by the multiplier), and inflation pressure can build. A higher interest rate does the opposite: borrowing and spending fall, and saving becomes more attractive.
Irish banks expanded credit rapidly, particularly for property loans, in the years before 2008. a) Explain how credit creation increases the money supply and the…
Irish banks expanded credit rapidly, particularly for property loans, in the years before 2008.
- a) Explain how credit creation increases the money supply and the possible effects on property prices and inflation.
- b) Explain how a fall in asset prices could reduce banks' capital and lending, with consequences for the wider economy.
- c) Discuss the role of the Central Bank of Ireland and of the ECB in regulating banks and the money supply, including capital requirements and mortgage lending rules.
- d) Evaluate whether stricter regulation could have prevented the crisis.
Back to the start: Aoife's parents' mortgage is a new loan. The bank credits their account (and, when they pay the seller, the seller's account), so a new deposit appears and the money supply increases. The bank can do this because it needs to hold only a fraction of deposits in reserve. If every bank does this at once, the whole money supply grows by a multiple of the original deposits.
Summary
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Commercial banks keep a fraction of deposits as reserves ($r$) and lend the rest. Each loan creates a new deposit, so banks create credit and the money supply grows.
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Money multiplier $= \frac{1}{r}$. Maximum rise in deposits $=$ initial deposit $\times \frac{1}{r}$. New loans $=$ total rise in deposits $-$ initial deposit. A higher $r$ gives a smaller multiplier.
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With a cash ratio $c$, the multiplier is $\frac{1}{r + c - rc}$. Cash drain, excess reserves and weak loan demand make the real multiplier smaller, so the central bank cannot control the money supply exactly.
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In the money market, demand for money slopes downwards and supply is vertical (set by the central bank). Equilibrium fixes the interest rate. An increase in supply lowers the rate and raises borrowing, investment and aggregate demand.
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The ECB sets euro area interest rates. The Central Bank of Ireland supervises Irish banks and sets capital requirements and mortgage lending rules. Credit booms can inflate asset prices, and falling prices reduce bank capital and lending.
Key terms: reserves, required reserve ratio, excess reserves, credit creation, money multiplier, cash drain, money supply, money market, interest rate, excess demand for money, capital requirements, credit union, Central Bank of Ireland, European Central Bank (ECB).