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How Commercial Banks Create Money
Now let’s look at how commercial banks (like Bank of America) create the type of money that appears in your bank account.
Loans
A customer, who we will call Robert, walks into BOA and asks to borrow $10,000 to buy a new car. Robert signs a contract with the bank confirming that he will repay $10,000 over a period of five years, plus interest. This legally enforceable contract represents a future income stream for the bank, and when the bank comes to draw up its balance sheet it will be included as an additional asset worth $10,000.
Robert, having committed to pay the bank $10,000, wants to receive his ‘loan.’ So BOA opens up an account for him, and types in $10,000. This is recorded as a liability on BOA’s balance sheet.
Notice that no money was transferred or taken from any other account. The bank simply updated a computer database. A bank does not really ‘lend’ money. To lend, one has to have money to lend in the first place. In reality a bank creates money, as credit, when it advances loans.
Buying Assets
Banks also create money when they buy assets, whether they are real or financial. For example, say Bank of America wished to buy a $10,000 government bond from a pension fund. Initially, BOA’s balance sheet appears as shown here.
In order to buy a bond, BOA creates an account for the pension fund and adds $10,000 to the balance. In exchange, the bank receives a government bond worth $10,000. Because BOA owns this asset, it can be placed on the asset side of its balance sheet.