I’ll have to be honest with you. I didn’t have a clue about the answer until very recently. This is something very simple yet worth knowing because the whole financial system relies on it. Here’s how it works.
To achieve this you need a bank. The dictionary will probably give you the following definition: “A place where lenders and borrowers meet” You put your money there so that you don’t have to deal with the stress of having it under your mattress, plus you make a little extra over time with interest. Or you can go to the bank and borrow some money to finance a purchase in exchange for a little interest on top for the bank so that it also gets its reward.
Mr. X and Mr. Y go to the bank today. Mr. X makes a deposit of 100 dollars and Mr. Y wants to borrow 100 dollars. The bank uses Mr. X’s money. In 10 years time Mr. Y will have repaid let’s say 150 dollars. Mr. X for his loyalty will get 120 dollars back and the bank will be happy with a 30-dollar profit. Easy. But that’s not exactly how you create money because the 50 dollars existed somewhere else.
Here’s how money creates money:
Let’s say you have 20 people who give 100 dollars to one bank. The bank has 2 000 dollars at its disposal. Person number 21 comes along and asks to borrow 100 dollars. “No problem let’s open an account for you sir. We’ll make a mark on your account and here you go, you have 100 dollars.” Question: How many people think they have 100 dollars? You guessed it: 21. There is now 2100 dollars. Money has just been created! Magic. That’s obviously as long as not everyone wants their money back at the same time. This won’t happen as long as everyone trusts his or her money is safe with the bank. This is why an imposing building and plenty of people wearing suits is important. It helps you trust them!
But it can go further than that. Banks are allowed to lend 90% of the money they have. That same 21st customer goes to another bank and deposits his 100 dollars. The bank lends 90% of it creating 90 dollars for Customer 22 who will go to a third bank to make a deposit for the 90 dollars. This third bank lends 81 dollars out of it etc… Basically 100 dollars can create 1000 dollars in the end.
Money supply depends heavily on credit, our most beloved modern lending mechanism. Changes in interest rates can affect greatly the amount of money available and lead to a financial crisis. But that’s another story.
