The Bank of England on money creation

Money creation makes people go nuts. Everyone can verify that claim by searching youtube for “money creation” or “money multiplier”, which will turn out a long list of clips telling you the SHOCKING TRUTH about our FRACTIONAL RESERVE BANKING system. Interestingly the money creation craze can be found on both ends of the political spectrum. To socialists, the fact that banks create money out of thin air proves that they are the ultimate force of evil in the world, designed to enslave the working class in a never-ending spiral of debt and compound interest. Libertarians, on the other hand, go “Money out of thin air! Inflation! Theft!”.

Introductory economics textbooks are partly to blame for this confusion. Most of them present an oversimplified model of money creation that goes something like this: there is an initial deposit of $100 with bank A. Bank A keeps 10% (say) as reserves and lends out the remaining $90. This new loan ends up as a deposit with bank B. Bank B keeps 10% of it as reserves and lends out $81, which will end up in bank C, and so on. By the magic of infinite series, the initial deposit of $100 creates new money in the amount of $1000; it gets multiplied by a factor equal to the inverse of the reserve ratio.

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