Credit Expansion 101—A Primer

Since credit is the last leg of economic capacitance, or nearly last, I’d like to revisit the creation of credit and its limitations before considering the timing of deflationary downturns.

Money supply is the sum of base money and credit. Credit is created from deposits through fractional reserve lending—which allows money to exist in two places at once: deposits are available to the depositor on demand, and at the same time all but the fractional reserve may be lent out. In this way, money has been created through lending. This is the first step in the expansion of money supply through credit.

If the fractional reserve rate is 20%, then 20 cents of every dollar must be kept in the bank while 80 cents can be lent out. Ultimately, through spending and re-depositing this 80 cents again and again through the fractional reserve system, that deposited dollar has been expanded five-fold. Every dollar lent can expand money supply by as much as $4 in a 20% fractional reserve system. Exactly how lending 80 cents of every deposited dollar expands money supply by a multiple of 5 was reviewed in this post, and links within explain it in more detail still. Similarly, lending 90 cents on the dollar, with 10% fractional reserves, expands money 10-fold, and lending 99 cents on the dollar expands money 100-fold, and as you go to 0% then money expansion points hyperbolically skyward to infinity. That is, assuming all money that can be lent out has been lent out.

So, with small changes in fractional reserves from 10% going toward the 0% range, we can get asymptotically huge increases in money supply so long as the banks desire to lend and borrowers want to borrow. If interest rates are suppressed by central banks, that will sweeten the pot. Money supply can easily be expanded to ones hearts content by reducing fractional reserve limits—until you run out of borrowers.

Capital that banks take in through the sales of commercial paper and securities vary from deposits in the sense there is no reserve, but it cannot exist in two places at once either, so no money creation can come of it. Same with TAFs and any other low-interest capital injections that banks get from the Fed. They allow additional lending from banks outside of the deposit base, but do not expand money supply.

If the Fed and the FDIC are willing to back deposits, which they are, fractional reserves can drop as necessary to allow money creation though credit to expand to the degree that society desires to borrow. The only limitation is what people are capable of borrowing. The next theory post will consider the limits of credit expansion from that perspective.