This is how banks create money out of thin air and is the cause of around 90% of of what is called "core" inflation (that is inflation not accounting for inflation caused by oil and food). The other 10% comes from inflation from the fed itself.
So here's the process. The government wants money, it creates bonds. The fed comes and buys these bonds with account entries in a computer. This money comes into existance the moment the the government bonds are bought (and is essentially free funding for the government, the federal income tax pays the interest on this money). Whereafter, the government bonds are held in ownership by the fed and considered as "assets". This process of creating money out of thin air by the fed accounts for around 10% of core inflation.
The other 90% of core inflation comes from the fractional reserve banking system. Here's how it works.
In the example diagram below, the initial 1,000,000 cash deposit is fed money (from buying government bonds just as described).
After this initial one million is deposited it goes into the bank vault (even though much of the process is electronic today, the bank vault helps conceptualize the process). Following the deposit an account entry is made for this 1 million as a bank asset. And yes this is correct, it is considered a bank asset because the money is available to the bank. The court systems have ruled in the banks favor on this for hundreds of years.
So now that the bank has an asset of 1 million, someone comes to the bank looking for a loan of 900,000. What the bank does is it takes 900,000 from the 1 million deposited in the vault and loans it out.
As this money is loaned out a promissory note is created (which is a bond, mortgages are an example of this). The note represents a contract for the money loaned out and is equivelent to cash as it can be sold to a third party. This promissory note is the money created out of thin air as the previous depositors money was just loaned out.
And then this process described above repeats itself as the loaned out money makes its way back into the banking system once again. Essentially, the same cash enters and exits the bank like a revolving door. And this money keeps getting loaned out over and over in dimishing amounts (due to a 10% required reserve to be kept each time it is loaned out) all the while these promissory notes (or bonds) are created in tandem with the process. This is how our money is created via the banks:
Also, as you can see the money is accounted in such a way that it "balances", this is how it is done on the bank balance sheet.
So if it isn't obvious already, if a large amount of people try to come and get their money out of the bank the bank can't provide it because it only has a reserve of 10% of people's money on hand. This was the problem with bank runs in the past. When the economy started to wane people went to get their physical money out of the bank en mass and the bank simply couldn't provide it and shut their doors.
Funny how we have the same exact banking system today, except people trust it more.
Before the fed was put into place, the government would mandate gold and silver money and the banks would create money off of that money like just described above. Individual bank runs were common and this is what eventually led to the people accepting a central bank or what is today the federal reserve. What the federal reserve does is act as a safety net in that if a bank run happens on a bank that is a member of the federal reserve system the fed can create new money out of thin air to pay the people that are trying to get the money out of their bank so "all is well". It is a crazy scheme but the banks have gained the trust of the general public and people have been taught to keep their money in the bank in instruments like CDs and money market accounts. And that's part of the key, as long as people trust the banking system is safe, it is safe. It is a faith based system. This is why the fed is very careful on what they say to the public because if people lose confidence in the economy their reaction could lead to a loss of trust in the system and a messy banking crisis as a result.
Another thing to note is that as these promissory notes are paid off they essentially vanish into nothing. And if all these notes in existance were paid off there would be no money in circulation in the economy. So today if people stop taking on more debt and work like crazy to pay off their current debt the amount of money in the economy would drop considerably. It's a sad fact to know that we are completely dependant on the banking system and are essentially working for it.
The benefit for the banks is tremendous because they get to charge interest on all this money they effortlessly create. If you take the initial 1 million in the example with a 10% reserve ratio as shown and the resulting 10 million created loaned out at 9% interest on average and 3% interest on average is paid to their deposit holders. That's 6% interest profit times 10 or roughly 60% interest profit based off of that initial 1 million loaned out. So $600,000 take 50,000 or so out for the bank's operational costs and you get the idea...
Banks are the most profitable companies in the world.
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