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Lesson 2, Topic 4
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4. How does deposit money emerge through lending? And how does it disappear again?

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Banks create their bank deposits primarily by granting loans. Let us have a look how this works, with the help of simplified T-accounts. Basically, the following applies: on the left, all asset items of a party are entered, which in the case of a checking account is the deposit money. On the right side, the liabilities are entered, that is the debts. In our example below, we assume that Marta takes out a loan for a racing bike.

First, Marta’s T-account is empty – she has neither money nor debts. Once Marta´s loan is granted, the bank will credit money to her account (on the assets side) and just by registering it, the money comes into existence. However simultaneously, a debt of the same amount is registered in Marta´s account (on the liabilities side). This represents money that Marta has to pay back in the future.

 

Marta now has freshly created money in her account which she can transfer to the bicycle dealer. This creates demand and revenue for the bicycle dealer, who will probably also pass the money on. Consequently, the money does not disappear, it simply continues circulating. At the end of the year statisticians will count it as additional savings in somebody else´s private checking account. Thus, Marta’s loan facilitated demand, revenue and money savings for other people in the economy. Marta herself now owns a bicycle, but as far as her account is concerned, the money is gone and only the debts remain. Her net assets are now -1000 euro. 

However, a few months later, Marta has an income of 1000 euro. Now again her account looks like in figure 2. When she uses the 1000 euros to pay back her loan, both entries disappear from her account, just as they appeared together initially: The 1000 euro she gained vanishes from the credit side because she uses the money to pay back the debt to the bank, and of course, the debt of 1000 euros is also cleared from her liabilities because it has now been paid off. And we are right back to the situation shown in figure 1.: here is again 1000 euro less in the world, but also 1000 euro less debt. 

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