The Association of Banks in Israel

Money Creation in the Modern Economy

Most of the economists define “money” as a combination of cash and bank demand deposits where the main part is demand deposits. The cash or the legal tender is created solely by the central bank in each country. The central bank determines the amount of banknotes and coins it wants to issue and when. The value of each banknote and each coin is also determined by the central bank.

In the modern economy, the largest part of money takes the form of bank deposits, and particularly demand deposits (in some countries the share is more than 80%). But, how those deposits are created is misunderstood or inappropriate. The principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s current account in a commercial bank, thereby creating new money.

The reality of how money is created in the modern economy differs from the description found in many textbooks, especially in the USA. Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits. Consequently, the central bank does not fix the amount of money in circulation, nor is central bank money (cash) “multiplied up” into more loans and deposits. Although commercial banks create money through lending, they cannot do so freely without limit. fte central bank limits them in two ways: the first is by determining the capital adequacy ratio. In Israel, the minimum ratio is 14%, which means that the total amount of loans must be, at the most, approximately 7 times the amount of own capital of every commercial bank. The second way is by fixing the interest rate, which affects the profitability of the loans.

The complete article in Hebrew appears on page 69