OK - the commercial banks can't simply create money as they like. There are some restrictions. The Central bank requires that the bank keeps a fraction of the deposits as 'reserve'. This is called the Fractional Reserve System.
The reserve is usually very small, 10% - 20%. The Central bank usually adjust the reserve requirement from time to time. You may think - the commercial banks can only loan out 80% of the deposits, that can't be too bad right?
This is the most deceiving aspect of the Fractional Reserve System. Let me show you why. Let say bank A obtained RM 1000 seed money from Bank Negara Malaysia. It can loan out RM 800 of it. Say the customer who took the loan wrote a cheque and buy a wedding ring, which got deposited into bank B. Now bank B can make a loan of RM 640 based on the deposit, and so on.
From RM 1000 of seed money from the Central Bank, the commercial banks can create a further RM 4000 of loans. If the reserve requirement is 10%, the extra loans that can be generated is 10 times the seed money.
Just how much of such money is being created? See the two charts attached, one for Britain, and one for Malaysia.
You may find it hard to quantify the amount shown in the graph. What is important is the exponential growth in the money supply. In both countries the money supply grew 100% in the 7 years leading to the financial meltdown in 2008. The relentless growth in money supply happened all over the world. It is the driving force behind the spectacular growth in share market and housing. Yes, it is the prime cause of inflation! And when it crash, the whole world CRASH together.
The technical name for these commercial bank created money is 'quasi money'. You are right, it is what the name says, they are not real money (which only the central bank can print). In fact, all money hold in the banks as bank balances are quasi money.
But for all intent and purposes, they function as real money. Try default on your house loan and you will know what I mean. From one person taking a loan to buy a house, the seller of the house will see an increase in his bank balance and use the 'money' to purchase further things.
This is the nature of digital money, as opposed to the physical notes and coins you have in your wallet. Any form of monetary transaction in digital form (cheques, bank transfers, credit card etc) can be traced back to a loan with a bank somewhere.
In Britain 97% of money in circulation are commercial bank created money, only less than 3% are physical money issued by the Central Bank. The figure is similar in other countries. In 2011 the total money supply of the world is 50 trillion USD, of which 48 trillion, or 96% are bank created quasi money.
Next: Money (3): Money Creation is in the Hands of Private Banks
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