Money & Credit
How Money Actually Moves Through the Economy**
Purpose
Explain how banks create money, how the financial system circulates that money, and why liquidity matters for preventing crises and supporting economic stability.
Core Principle
Banks = The System That Turns Credit Into Money**
Banks do two critical things:
Create new money through lending
Move money through the economy’s plumbing system
When banks lend, money supply expands.
When banks tighten, money supply contracts.
Banks are not just intermediaries — they are money creators.
The Three Banking Functions
The banking system affects the economy through three essential mechanisms:
1. Money Creation Through Lending — The Multiplier
When a bank issues a loan:
it creates a deposit
the deposit becomes new money
the borrower spends it
the money circulates through the economy
Example:
A $300,000 mortgage is new money created out of credit.
This is the core of modern monetary systems.
Banks expand money when:
lending standards are loose
confidence is high
borrowers are willing
collateral values are rising
Banks contract money when lending slows.
2. Liquidity & Payment Systems — The Plumbing
The banking system is the infrastructure that allows money to move.
Banks run:
checking and savings accounts
ACH transfers
wires
credit card networks
settlement systems
The economy functions only when:
payments clear
deposits move easily
cash is available
liquidity is stable
When plumbing fails, the entire system freezes — even if the real economy is healthy.
3. Risk Management & Fragility — Why Crisis Happens Fast
Banks borrow short and lend long:
deposits = short-term liabilities
loans = long-term assets
This creates fragility:
If too many depositors withdraw at once → a bank run.
If asset values fall → capital problems.
If funding dries up → liquidity crisis.
Banks are safe when:
depositors trust the system
assets are stable
collateral values hold
liquidity is available
They are vulnerable when trust breaks — quickly and unexpectedly.
How Liquidity Crises Occur
Liquidity crises happen when:
banks stop lending to each other
depositors withdraw cash
funding markets freeze
collateral values fall
uncertainty spikes
In failure events (Lehman, SVB, 2008), the issue is not solvency first — it is liquidity.
Liquidity problems cause collapses in days.
Solvency problems take years.
The Banking Equation
The dynamics of banking can be summarized as:
Money Supply = Base Money + Bank Lending – Loan Repayments
When lending is strong → money grows.
When lending stops → money contracts.
What This Explains
Understanding the financial plumbing clarifies:
why 2008 was a liquidity crisis, not just a housing collapse
why bank failures can trigger recessions
why governments guarantee deposits
why central banks act as lenders of last resort
why liquidity injections stabilize markets
why credit freezes cause layoffs and production cuts
why banks matter even if you never use credit
Why This Comes After Money & Credit
Money is the foundation.
Credit amplifies demand.
Banks are the mechanism that creates and circulates both.
You must understand:
how money is created
how credit becomes money
how liquidity supports stability
how bank fragility triggers recessions
The banking system is the invisible infrastructure behind all economic behavior.