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Bankers know how to generate money out of narrow air. In fact, banks are money factories. Banks exist to make money. You might think that banks are in business to provide services such as banking accounts and loans to their customers. It is true that banks provide essential financial services. However, the reason that the banks provide such services is that banks need money to use as raw material to generate more money. Where does this money come from? It comes from customer deposits. In other words, it comes from the money you and I deposit in to the bank.

Here is an example of how banks generate money. You deposit $100,000 in to a one-year Certificate of Deposit at 5% interest. The bank now can use your money to generate loans.

Notice very carefully, banks “create” money. It is not basically that banks “earn” profits when they provide bank services and loans. Banks actually “create” new money that did not exist before.

So, the bank makes Loan #1 of $90,000 and keeps $10,000 on reserve. This is the critical point where the bank creates money. According to the bank’s balance sheet, the $90,000 loan to the borrower is as well as a $90,000 asset for the bank. By its own brand of money magic, the bank has created $90,000 out of narrow air.

The Federal Reserve sets the reserve rate for the bank from 3-10%. A 3% reserve rate means that the bank must keep 3% of the $100,000 on reserve and can loan the remaining 97%. A 10% reserve rate means that the bank must keep 10% of the $100,000 on reserve and can loan the remaining 90%. For our example, let’s assume that the reserve rate is 10%. This allows the bank to loan $90,000 of your $100,000 deposit.

But the method does not stop here. Since the bank now has an asset of $90,000, it can make another loan based on this asset. Since the same Federal Reserve rules apply, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $90,000. This means that Loan #2 is $81,000. By generating another loan, the bank has created another asset. The $81,000 loan to the borrower becomes an $81,000 asset for the bank. One times again the bank creates money out of narrow air.

And since the bank now has an additional $81,000 asset, it can make another loan. One times again, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $81,000 asset. Loan #3 is $72,900.

You deposit $100,000 in to a CD. The bank creates one loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

Federal Reserve rules permit the bank to make one to four loans based on the original $100,000 deposit. Each loan creates an additional asset. We’ll stop at one loans, review the method, and add up how much money the bank has created.

To make this point, I have oversimplified the method. A bank doesn’t make a series of separate loans based on a single deposit. Your deposits become part of a pool of money the bank can use to make loans. But this oversimplified example demonstrates how banks generate money out of narrow air. A bank manufactures money by using the deposits of customers to make loans. The loans become assets and the assets turn in to money.

When you funds out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 – $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this method is. This is how banks generate money.

The method a bank uses to generate money demonstrates that money is not a commodity in limited supply, where there is only so much to go around. Money is not equivalent to funds. Money is created in money-making transactions, which means there is no potential limit to money.

What difference does it make to see how banks use money to generate money? You and I cannot do what banks do, by loaning on the same money over one times. The real point of this example is to take some of the mystery out of money.

So, if you need more money, think the way bankers think. Ask how you can use money to generate more money. If you think the way bankers think, you will use anyone else’s money to generate more money. The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited.