Let's review what happens when you put money in the bank.
We set up the banks accounting using a simple T account. The T account has two sides. The right side of the account includes liabilities - amounts that the bank owes. The left side of the T account summarizes the bank's assets. Accountants make sure that the sides equal each other, or balance.
When a customer puts money in a small commercial bank, the deposit shows on the liability side of the bank, since the bank now owes money to the customer. Let's assume that the customer deposits 50¢. Now that the customer has deposited 50¢ in the bank, the bank has to keep some of that money. The bank cannot lend all the money deposited because there is a Federal Reserve regulation that requires the commercial bank to keep reserves.
Let's say that the bank has to set aside 10% of money deposited as reserves. The bank then sets aside 5¢ as reserves. This asset is set aside and recorded as an asset on the left side of the T account. The remaining 45¢ left from the deposit, can be loaned out. The bank, naturally, lends this money to borrowing customers at a higher interest rate than the bank is paying its deposit customers. That is how the bank makes a profit.
The bank lends the 45¢ and that borrower uses the money to buy a boat, a car a piece of machinery or for some other purpose. The person or company that receives the payment then deposits that money into their account at a different bank. The second bank is also going to set aside 10% of this deposit (about 5¢) for reserves.
The second bank can now lend 40¢ of the 45¢ that the bank received, to one of its customers who needs a loan.
When the second bank lends the 40¢, and that money is spent, the person or company receiving the 40¢ then deposits that money into a third bank. The third bank keeps 4¢ in reserve and then lends 36¢ to another borrower. Three loans of 45¢, 40¢ and 36¢, respectively, have been made by the banks. Add these three loans together and they total $1.21. The process has created 71¢, the difference between the original deposit of 50¢ and the $1.21 of new money that was loaned. These loans help bank borrowers purchase real goods and services.
In this example, the initial deposit of 50¢ helped create 71¢ in new money. That is how a fractional reserve banking system works and how money is created.
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