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Credit Creation Theory: The Concept of Money & How It Is Circulated
Credit Creation Theory: The Concept of Money & How It Is Circulated
As discussed in my previous post, this week I will be focusing on specifically on the credit creation
theory of banking. Dr. Werner ultimately makes the case that this is the most compelling theory of
banking because it most accurately depicts how the current financial system functions at the
transactional level. I tend to agree with his assessment and find the credit creation theory to be a
helpful lens through which to view the current financial system. Moreover, if you accept the tenets of
this theory, deficits in monetary policy and banking regulations start to appear. This post will focus
on the concept of money, how it is circulated and the logic of credit creation.
Credit money represents the total amount of money that is owed to banks by borrowers and it only
remains valid so long as the bank is solvent. Though it is intuitive to assume that as a loan is paid
back to a bank the money supply would expand, the opposite is actually true. Bank deposits basically
represent an IOU between a commercial bank and their clients (represented by both individuals and
organizations). Again, when a commercial bank lends money, they are technically creating a deposit
in another account. Moreover, when individuals deposit their money in a bank they are technically
serving as a creditor to the bank, which in turn reserves the right to deploy the depositors’ capital as
they see fit. This dynamic is important to understand in order to grasp the credit creation theory of
banking at a high level.
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Ultimately, this theory makes the case that banks are capable of creating an endless supply of money
through their lending activities. When viewed from this perspective, current and past financial crises,
as well as interventions from the Fed begin to make sense.
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