Money, Banking, and Credit

Prerequisites: Income, Wealth, and Inequality · GDP and National Income

Banks issue loans of 60, and your account balance immediately increases by 60. Did they first take 60 from another depositor and then give it to you? When you transfer the money to a merchant at another bank, does that loan then disappear? To answer these questions, you must look at the accounts of the bank, the borrower, and the payee simultaneously.

This article distinguishes between deposits, reserves, loan assets, and net wealth using one loan, one interbank purchase, and one branch for principal repayment. Amounts are in teaching units; fees, interest, and taxes are ignored. Bank B only shows the changes from this specific transaction and does not assume the real bank has no other assets or liabilities.

First, identify the holder and issuer of "money"

Bank deposits held by households are assets for households and liabilities for commercial banks. Reserves held by banks at the central bank are assets for the banks and liabilities for the central bank. The holders and usage scenarios differ: households typically use deposits for payments, while interbank settlements involve the transfer of reserves.

Cash, bank deposits, and other highly liquid instruments may fall under different monetary aggregates, depending on the country and the specific indicator. Here, we focus on everyday spendable bank deposits, not labeling all financial assets as money that can directly buy breakfast.

All accounts obey the equation Assets = Liabilities + Equity. Equity is the net asset value after deducting liabilities; it is not a bag of cash kept separately on the counter.

Step 1: Loans and deposits appear together

Bank A initially has reserve assets of 100, deposit liabilities of 80, and equity of 20. The original 80 in deposits belong to other customers. The borrower initially has no deposits or debts. The merchant holds unsold goods with a cost value of 60.

When A issues a loan of 60 and credits it to the borrower's deposit:

Bank A now has assets of 100+60=160 and liabilities plus equity of 140+20=160. There is no need to deduct 60 from the original depositor in this accounting entry. The loan created a corresponding deposit but did not create 60 of net wealth for the borrower: their spendable assets and repayment obligations increased simultaneously.

This also did not directly create new machines, food, or housing. How the borrower's increased purchasing power affects real output or prices depends on what they buy, whether firms have idle resources, and how other entities react.

Step 2: Buying goods and interbank settlement

The borrower uses this 60 to buy the merchant's existing goods, and the merchant's account is at Bank B. Simplified as an immediate interbank settlement:

After the transfer, A's reserves are 40, loans 60, deposits 80, and equity 20, remaining balanced. B increases reserves by 60 and deposit liabilities by 60 due to this transaction. Total deposits across both banks remain 140: they moved from the borrower's name to the merchant's name and were not destroyed by the interbank payment.

Total reserves across both banks remain 100; they were merely transferred. The borrower's loan remains on the asset side of A. Buying goods does not equal repaying the loan. Confusing loan balances with payment account balances leads to misreading all three accounts here.

View the four-party accounts in the order of "pre-loan → loan issuance → interbank payment." The changing items show increases or decreases compared to the previous business step. Bank B is the account with changes; the merchant's goods are treated at transaction value equal to book value in this example; other activities are not included in the model.

Step 3 is another branch: Repaying principal with unspent deposits

Return to the point just after the loan was issued but before any purchase. The borrower decides to immediately repay a principal of 20. A simultaneously reduces its loan asset to the borrower by 20 and its deposit liability by 20; the borrower's deposit and loan liability each decrease by 20.

Thus, A's loans go from 60 to 40, and deposits from 140 to 120, while reserves remain 100 and equity remains 20; the borrower is left with 40 in deposits and 40 in debt. Principal repayment in this branch reduces the deposits created by the bank's lending.

The interactive "repayment of principal" starts from the loan state before the purchase, while the deposit is still unspent, not from a situation where the merchant has already received payment and the borrower suddenly has an extra 20. If repayment occurs after an interbank purchase, it must first be explained how the borrower obtained funds from wages, asset sales, or other sources, and then how the relevant interbank transfers are completed.

Interest is a different type of payment; it affects bank income and the parties’ net worth, and one cannot mechanically apply the entry "principal and corresponding loan balance decrease by the same amount." Loan write-downs are also different: if A determines that 10 of the loan is unrecoverable, the loan asset and equity each decrease by 10, and deposit liabilities do not automatically decrease by 10.

Since we can make accounting entries, why can't we lend infinitely

Step 1 only shows the loan entry; it does not mean subsequent constraints disappear. When the borrower transfers deposits out, the bank needs available settlement assets or funding sources; insufficient reserves may require interbank financing, asset sales, or eligible central bank financing, all of which have price, collateral, and eligibility constraints.

Banks must also bear loan default risk, meet capital and liquidity requirements, and assess whether future income covers financing and operating costs. Borrowers also need repayment capacity and willingness to borrow. Balancing the books is a necessary condition, but not a sufficient one for the economic feasibility or regulatory permissibility of the loan.

A story that simply multiplies reserves by a fixed factor omits the interactions among loan demand, lending decisions, settlement, capital, and prices. Multiplier formulas under specific reserve regimes can describe certain hypothetical relationships, but they cannot be treated as the operational sequence that every modern bank transaction necessarily follows.

Also distinguish between liquidity and solvency: having valuable assets but temporarily lacking settlement funds is a liquidity problem; asset losses exceeding equity involve solvency. The two may worsen each other, but borrowing short-term cash does not mean asset losses have already been repaired.

How bank credit connects to the real economy

Loans can support businesses buying new equipment or households buying goods, but they may also be used to purchase existing assets. The former may be linked to new production, while the latter mainly changes asset holders and prices. Not all new credit can be directly added to GDP.

When many people are eager to reduce debt, new loans may be less than principal repayments, putting contractionary pressure on deposits and spending. If consumption and investment are cut simultaneously, it will affect business orders and income. This is a transmission chain that requires continued analysis; it is not an economic recession with a fixed multiplier derived from a single entry.

The central bank influences the settlement system and financing conditions, but an increase in commercial bank reserves does not automatically translate into household consumption. We need to continue asking about the specific links of loans, interest rates, asset trading, and spending decisions; the two lessons on interest rates and policy will unfold separately.

Use four-party accounts to dispel illusions

After the borrower takes a loan of 60 and transfers it all to the merchant at B, some say "A's customer deposits decreased by 60, so the banking system's money supply decreased by 60." What was missed?

A recognizes a loss of 10 on the newly issued loan. Some say "the borrower doesn't have to repay this 10, so other depositors' accounts should also decrease by 10, and the bank balances." What is the correct basic entry?

Sources and Further Reading

These references support concepts and statistical definitions; the numerical cases and diagrams are original synthetic teaching examples.

Bank of England · Money Creation in the Modern Economy