Textbook example — Emmef / Society / Money / Banks

For this explanation, the economy contains a fixed amount of money that does not change during the example. There is only one bank that has two kinds of accounts: payment accounts without interest and savings accounts with interest. This explanation does not describe reality, so reading it as if you have no previous knowledge of banking is advisable.

In an ideal situation, all money circulates continuously between payment accounts: it is spent all the time. Some people cannot spend all the money they get and the want to save that up. Some entrepreneurs temporarily need extra money to make nice things happen. If savings would take money out of circulation that could be used by entrepreneurs, that would be a waste! The savings account solves this problem, without the need for one on one transactions between entrepreneurs and people with savings.

Let's take a look at the bank that has, for example, 4 creditors with savings accounts SA … SA 4 and a total amount of savings $$T_s$$ 1:

 SA 1 SA 2 SA 3 SA 4 $$T_s$$

The bank is allowed to lend out savings to debtors. Because lending out money involves a certain risk and there's always a chance of creditors that take their money out of their savings account, the bank is legally obligated to retain a certain percentage of the money that it manages. This is called the minimum buffer percentage, $$b$$ that needs to be larger than zero but lower than a hundred percent. The total amount of outstanding debt, $$T_d$$ and the buffer $$B$$ can be pictured as follows:

 SA 1 SA 2 SA 3 SA 4 $$T_s$$ $$T_d < (1 - b)T_s$$ $$B > bT_s$$

## How does lending out work?

When the bank lends out money, it creates a contract that describes the amount of money and a schedule for both repaying the money and paying the interest. Sometimes, additional conditions apply, such as surity. When this contract is signed by bank and debtor, the bank moves money from the pool of savings to the payment account of the debtor. The debtor can then move this money from the payment account to the payment account of someone else. As long as the debtor meets the criteria in the debt-contract, everything works.

It is possible that a debtor cannot repay his debt or the interest that is due. This is the reason that there must always be a buffer of money that is not lend out. In addition, interest income can also be added as extra buffer.

## Bank-run

Imagine that a large percentage of the money in savings accounts is pulled out by the owners of the accounts. If the bank already has the maximum amount of money lend out, it needs to violate the law to give that money back. Therefore, banks need an additional buffer on top of the minimum allowed by law. In addition, banks will also offer accounts that need people to keep the savings for at least a fixed a mount of time, so that risk is reduced.

## Multiplying money

As said the debtor is free to use the loan as desired, apart from the schedule of repayment and paying debt and additional criteria in the debt-contract. The debtor could be payed in full to a landlord. This landlord could then transfer the money from his payment to his savings account. In turn, this means that the bank is allowed to lend out more money. Which could, again, end up on a savings account. And so on. With a buffer percentage $$b$$ this leads to a maximum percveived growth of money in circulation of $$\frac{1}{b}-1$$ 2.