Economics Essay Example: Loanable Funds and Money Creation in Banks

Money creation is a bizarre thing to ponder and many individuals have no idea how money is created by the banks. Suppose a person walks in a brand new bank that has just been opened with no deposits, and deposits $5000. This means that this individual has that amount as his asset in the bank account and the bank has the same amount of money but as a liability. Since the rule of the book put forward by the federal government allows banks to loan out a fraction of the money they have in deposits to others a process called "fractional reserve banking" (Akram, 2009).

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Since banks make money through borrowing at one rate and loaning at a higher rate, the bank in our example then locates an individual that want to borrow $ 4500 (any bank can loan up to 90% of its reserve). The borrower would then spend that amount by giving it to another person who, in turn, deposit it in a bank. With the new deposit, the bank has new $4500 and the bank looks anyone who want to borrow $4050 (90% of 4500). And so the bank will again get new deposit of $4050 which is spent and a fresh deposit is bank and the bank will have $4050 to loan out at 90% of $4050 which gives $3645. With the initial $5000, the bank is able to have $12195.

This illustration shows that initially we had $5000 in the reserve bank and $12195 in various bank accounts and $7195of new debt. The initial $5000 is in the bank reserve but then every new dollar, all $7195 of them was loaned and is 'backed 'by equivalent amount of debt. Now, this mechanism of creating new money out of deposits works as long as nobody defaults. This in the basic terms is how money is created. Although there is gap in this story for we did not also look at the effect of interest rates that banks charge for borrowing and loaning, but all the same, we will look at how money is created in the explanations to follow latter in this work.

In the capital markets, firms and /or business organizations are demanders of capital while the households are suppliers of capital. This has the implication that households supply capital goods by saving a portion/fraction of their income and lending these saving to the banks. The banks, then, lend household saving to firm at a higher interest rate than which they give the households. This creates loanable funds within the capital market. Loanable funds refers to the funds available for borrowing and consists of household savings and/or bank loans. Investment in new capital goods is often made with loanable funds (Solow, 2016).

Difference between Loanable Funds and Money Creation in Banks

There are differences between loanable funds and money creation by the banking sector. To discuss this, we first look at money creation in bank then we discuss loanable funds in detail.

Money Creation in Banks

According to Sir Mervyn King, Governor of the Bank of England (2003-2013), the extensions of money by banks facilitate the creation of credits on consumers". Money exist to be able to facilitate the making possible payment any transaction. Money therefore consist of bank deposits, cash-in-pocket/at hand. Most money in any economy is created by banks in form of bank deposits and the banks do this whenever they give out loans to individuals, businesses, organizations or governments. It is imperative to note that the government only creates 3% of the money in an economy whilst the banks create 97%. It is also important to note that banks don't create the paper money that an individual can touch but the money they create is the electronic bank deposits that flashes on whenever you check your balance account and this accounts for the 97%. The 3% is the cash that people carry in form of cash at hand. (Both coin and paper money) that which is created by the government.

When banks issue out loans, then they are said to create money through accounting. The balances in the bank accounts are accounting entries known as "liability" or "I Owe You" from your bank to you. In other words they are debts that you owe the bank and you are able to spend those using electronic means or you can withdraw them from your account using your debit card in form of cash. By the banks creating electronic IOUs, they can then create an alternative for money (Solow, 2016).

The Bank of England released a report in March 2104 called dubbed creation in modern Economy. It reported that the commercial banks create money through bank deposits and establishing new loans. For example, this can be made possible for an individual taking out a mortgage to purchase a house. Under these circumstances, the banks does not create credit by awarding thousands of money but credits customer's bank account with bank deposits of mortgage sizes. In addition, any move by the bank to gives a new loan, it creates a new money and debt (Solow, 2016). Over the past 5 decades, commercial banks have raised the amount of money in circulation by giving out the loans to people leading the rise of products over a considerable period of time.

Loanable funds

The loanable funds theory owes its origin to the Swedish economists, Knut Wicksell. Fundamentally, the theory utilizes classical market analysis to offer the description of the supply, demand as well as the interests' rates for the loans in the market for the loanable funds. The loanable funds doctrine holds that the interest rate is determined by the supply of and the demand for the loanable funds. Notably, the loanable funds can therefore be described as the sum total money saved by the individuals and others entities for the consumption and investment purposes.

For individuals, organizations, governments and businesses that have decided to save part of their money for investment purposes and not to spend their money is the main source of loanable funds for people and organization for they will borrow the saved money at a given interest in form of loans (Stiglitz and Rosengard, 2015). Organizations seek loans to pay for overhead expenses and to pay for capital assets. Individuals also seek loans may be inform of mortgages and to buy assets that increases their value over time. The desire for investment through borrowing loans gears the demand for loanable funds (Solow, 2016).

The theory of loanable funds states that the rate of interest is determined by the supply and demand for loanable funds. It is therefore said to be wider than the classical theory of interest. In this respect we are going to look at the demand and supply for loanable funds.

Demand for loanable funds

The demand of loanable funds is obtained from various sources that include dissaving, investment and hoarding. They are discussed below:

Dissaving (DS)

This is derived from people who spend beyond their income at any particular time. It is therefore said to be a decreasing function of interest rate.in other word, dissaving is said to be the opposite of saving (Solow, 2016).

Investment (I)

The investment (I) refers to the expenses involved in the purchase of new capital goods that include but not limited to the inventories. Fundamentally, the interest rate determines the purchases. This further implies that an investor must conduct a comparison of the rate of return from the investment with the rate of interests. The demand for the loanable funds aimed for investments will decrease when the rate of interest are high and vice versa. Undeniably, an inverse relationship between the demands for loanable funds for investments to the rate of interest exists.

Hoarding (H)

Individuals, organizations, or businesses who hoard loanable funds as idle cash to satisfy their ego for liquidity creates the demand for loanable funds. Hoarding therefore decreases rate of interest and at low rate of interest for demand for loanable funds, hoarding will be more and at high rate of interest for loanable funds, hoarding will be less (Solow, 2016).

Supply of loanable funds

This is derived from the following four basic sources that include; savings, dishoarding, bank money and disinvestment. They are dependent upon interest rate which has the implication that they are interest elastic. They are discussed below

Savings (S)

This constitutes the difference between income and expenditure and it is the main source of supply for loanable funds. The amount of savings changes with rate of interest since it is believed that income static. This therefore shows that individuals and organizations save more at high rate interest and save less at low interest rates. D.H. Robertson took savings as the difference between the income of the previous period and consumption of the current period (S = Yt-1- Ct). In both the loanable fund theory and classical theory, they believed that saving was interest elastic. That is to say, they assumed that the volume of saving increased with increase in income and it reduced with the reduction of income. On the other hand, the neoclassical theorist contended that with the level of income, then saving often varied with the interest rates

Dishoarding (DH)

Individuals and businesses dishoard money from the past hoarding at a higher interest rate and this is because at higher rate of interest, the idle cash of the past becomes more active now for investment. Therefore at low rate of interest, DS becomes negligible if not zero (Solow, 2016).

Disinvestment (DI)

Disinvestment is also a source of supply for loanable fund and it results when stock of capital wears and tears out without replacement by a new equipment. If present rate of interest produces better returns compared to present earning, then, disinvestment will always be high. High rate of interest on loanable funds allows people to embrace disinvestment. Disinvestment is essential in numerous ways. Firstly, it lies in the utilization of funds for financing the increasing fiscal deficit. The disinvestment further helps in the financing of the large-scale infrastructure development. Through disinvestment, the governments have been able to invest in the economy with the aim of encouraging people to spend. Besides, the process helps in the utilization of funds for the social programs like health and education. Finally, the government, through disinvestments may assume the significance based on the prevalence of an increasingly competitive environment, thereby making it difficult for many people to companies to operate profitably. This ultimately promotes a rapid erosion of the value of the public assets thus making it essential to disinvest early to realize a huge benefit (Mankiw, 2014).

Bank Money (BM)

When banks issue loans to business individuals or organizations through credit creation, this becomes a source of supply of loanable funds. This money (loans) therefore adds to the supply of loanable funds.

Determination of Rate of interest

According to Knut WIcksell, who was the proponent of the Loanable funds theory, the point at which demand for loanable fund equates supply for loanable fund is known as the equilibrium rate of interest. This can be illustrated using the below diagram:

The above graph have X-and Y-axes. The x-axis is demand and supply of loanable funds while at the y-axis is the rate of interest. In the figure, DL represents the demand for loanable funds while SL represents the supply for loanable fund. The point of intersection between DL and SL is at EM which is referred to as the equilibrium rate of interest (Jakab and Kumhof, 2015).

Criticism of Loanable Funds theory:

The concept of the loan able funds is a theoretical analysis put forward by Lord J. M. Keynes as the chief critics in the loanable fund theory. Notably, the loan able theory was an extension of the classical theory since a number of aspects derived from the classical theoretical approach.

On the other hand, criticism theory basically focuses on the general aspects that made the autho...