Banks don't actually borrow the money. They create it. The fact that people don't understand and are completely unaware of this is THE problem with the banking system:
http://www.theguardian.com/commentisfree/2014/mar/18/truth-m...
Banks do not create money out of thin air: central banks do. Through loans to charter banks and bond purchases, the Federal Reserve creates (or destroys) money whenever the internal one day inter-bank loan market interest rate is above (or below) a certain guideline (the "interest rate").
On the other hand, if I deposit $100.00, the bank is allowed to loan a certain percentage of it to someone else. That is fractional reserve banking. Let's say the bank operates with a 2% reserve. I deposit $100.00, they loan $98.00 to Johnny. A naive understanding of the system would lead you to think that the bank "created" $98.00 because the sum of the balances of yours and Johnny's bank account is $198.00; it did not. If Johnny doesn't pay his loan back, they're out $98.00. Your deposit is a liability for the bank. The loan is an asset. So in this situation, the bank has $100.00 in liabilities, $98.00 in assets and $100.00 in reserve.
When too many people don't pay their loans back, you have a bank run. Part of the reason the Federal Reserve system exists is to avoid this situation by allowing the banks to borrow from a lender of "last resort" if this were to happen.
> Bottomline is, the loan is an asset and the deposit is a liability.
I used to be as skeptical as you about the full-reserve crowd but that point is actually what got me thinking: banks are the only players in the economy for whom giving out loans is a balance-sheet extension (what you're describing). They're worth more, the more loans they give out.
For everybody else, giving out a loan doesn't change their net worth! They're just exchanging one asset (money) against another asset (an IOU from someone). In other words: banks are special and are not allowed to fail, because we let them create money.
Definition of M0, M1, M2, M3, M4 [1]
>Different measures of money supply. Not all of them are widely used and the exact classifications depend on the country. M0 and M1, also called narrow money, normally include coins and notes in circulation and other money equivalents that are easily convertible into cash. M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds. M3 includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity. The exact definitions of the three measures depend on the country. M4 includes M3 plus other deposits. The term broad money is used to describe M2, M3 or M4, depending on the local practice.
I think that's not exactly true. The reality is that banks make loans and then search for the reserves. So, in practice, are the credit departments in commercial bank who decide if new money is created. Central banks can influence this by making the creation of new money cheaper or expensive.
http://www.economonitor.com/lrwray/2013/08/15/banks-dont-len...
To anyone interested in these issues, I recommend Modern Money Theory ( http://neweconomicperspectives.org/modern-monetary-theory-pr... ).
"In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans."
"Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits."
"Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits."
"The amount of money created in the economy ultimately depends on the monetary policy of the central bank. In normal times, this is carried out by setting interest rates. The central bank can also affect the amount of money directly through purchasing assets or ‘quantitative easing’."
I recommend reading the whole report. It is meant to be readable by the non-academic and is not dumbed down either. The report is part of Bank of England's Quarterly Bulletin from 2014[1], it contains other similar articles like "Money in the modern economy: an introduction."
[0](http://www.bankofengland.co.uk/publications/Documents/quarte...) [1](http://www.bankofengland.co.uk/publications/Pages/quarterlyb...)
[1]: http://www.theguardian.com/business/2015/may/27/bank-of-engl...
So with 2% it's much more than that.
Private banks aren't creating money, the central bank is. You've confused the two.
Which brings me to your own "M2 is derived from M0". There are certainly interpretations of that statement with which I would agree, but there are also interpretations which are seriously dubious. For example, the interpretation that "there is a causal mechanism from the quantity of M0 to the quantity of M2" is highly doubtful. The economists who actually study those things seem to come down mostly on the side of endogenous money, which says that the causality is the other way around: "changes in M2 drive changes in M0" - or rather, they did before interest rates went to the zero lower bound, at which point the two quantities became decoupled.
The Federal Reserve, on the other hand, can create money from nothing and use that to buy government bonds, like they did with QE.
it affects inflation, if not as much as M0 does iirc. (its been a while since I've taken econ, so i'm a little fuzzy on that)
This all works fine assuming you don't try to withdraw all $100 since they only have $20 on hand. Nor would it be good if Erin defaults on her debt. Or the bank collapses. This is what FDIC is there to protect, where the government will create new money in case things collapse.
And what will Erin do with that money? She will give it to Tony in exchange for some service. What will Tony do? Pay that into his bank account. Which means the bank now has an extra $70 (assuming they keep a $10 reserve) that it can loan out, bringing the total amount of money in our economy to $250.
Also that $80 that Erin borrows will need to be paid back with interest. Say the interest is $20. She pays back $100. The bank now has $120. That $20 that she paid back had to come from somewhere. Say she sold a blanket she knitted to Paul to make that extra $20. Where did Paul get that money from? He had to borrow it from the bank. And the cycle continues...
Yeah but Erin had to put his house for getting his loan.
Everyone's a bit confused. Or talking at cross purposes.
* Central banks create M0 (either paper currency, or electronic equivalents - original fiat money). (I had to say fiat, or some gold bug would complain that gold is the real money).
* Banks borrow money, lend it out again, then when the money comes back to the banks they keep recyling it in an infinite cycle, creating M0/fr amount of broad money (M2?).
* Then other infinite cycles create even broader money, but let's forget about that.
A lot of people (especially bitcoin and gold proponents) forget is that the government can still create M0 if it's not just greenbacks (by lending out "imaginary" gold or bitcoins - as long as someone will take an IOU from the government in return for a little bit of interest). Banks can create M2, as long as someone will take their IOUs (with interest). You can ban lending, but since the critics of money usually lean Libertarian, that's not an argument you often get.
What some post-keynesians and some economically literate marxists (and maybe MMTists, I don't actually know what they're on about) suggest is that the fraction can suddenly change.
Boom - lowering fractional reserves, which means the total amount of broad money keeps increasing.
Bust - banks try to lower fractional reserves, which makes the total amount of broad money contracts.
The fraction is often treated as a constant, but if it suddenly changes (or the desired target suddenly changes), it can have a massive impact.
Banks get very comfy lending out money with very low reserve rates (effectively the multiplier of money), because whenever there's a crisis the government will "print" M0, and hand it over. So as long as the banks don't act more irresponsibly than every other bank, they can't fail. "Macroprudential" reforms (telling banks to stop it when they lend to much, or risk fines / penalties) is becoming fashionable for this very reason, since telling banks they'll all go bankrupt is about as credible as a teacher yelling "If the class isn't quiet I'll expel the lot of you!".
I like to consider the human side - in the asset bubble that occurs when M2 is rapidly growing, everyone wants to work hard and save hard, because otherwise they'll never get on the property ladder. That creates a boom, then a bust when they realise it's a Ponzi scheme. Economists who know better talk about high investment, then a crash in investment when the money suddenly dries up.
(See analogy above, do not assume I see this as good educational practise)
The general thrust of what you're saying is correct, though: If you want to understand how money enters the circulation among the general public, you absolutely have to look at banks. The central bank and the government have almost nothing to do with it outside of their regulatory function.