We haven't had any MMT for a few days, so I thought I'd bring some back. Recently I've been discussing banking in other places with an MMT supporter. I think this is a good opportunity to give a simple explanation of the loanable funds market, and why it actually does exist. It's a chance to explain criticisms of MMT in a simple way.

That person pointed me to the "Econviz" website. It gives an explanation of loans which is confusing and incomplete, see here. I'll base my explanation on that one, but I'll go all the way to the end. I'll also avoid the potentially confusing word "deposit".

Firstly, Joe wants to buy a used car and applies for a $100 bank loan to pay for it. The website gives a nice picture of a car, which is ironic given what happens later....

Joe has a balance of $50 in his bank account. His net worth is $50.

Joe's loan is approved. His bank balance is increased by $100, so after the loan is granted the balance is $150. Joe is in debt to the bank, of course. He owes them $50, so his net worth remains $50.

I can present Joe's situation as a balance sheet at the start:

Joe has no liabilities until he takes out the loan, then his balance sheet looks like this:

Joe has a $50 net worth because $150 - $100 = $50.

What about the bank. Now, the website makes Joe the only customer of the bank. I'll do that too. But I'll give the bank more reserves at the start because if I didn't then the bank would be in a perilous situation at the end of the explanation! I'll give the bank $200 of reserves at the start.

This is the bank's balance sheet at the start before the loan:

What is the $50? That's the $50 balance that Joe had at the start. To the bank it's a liability. That's because the bank owes Joe $50. That what it means to have a balance in a bank account, it means you have loaned to the bank.

The bank's net worth is $200-$50 = $150.

Then, this is the bank's balance sheet just after the loan is granted:

The loan is an asset to the bank. That's because Joe has promised to pay it back. The bank balances are now $150 because of the extra $100 that the bank put into Joe's account.

Now, the bank's net worth hasn't changed $300 - $150 = $150.

The explanation on the EconViz website then says this: "Here's the really counter-intuitive part -- the bank's reserves didn't go anywhere!"

The problem with this is that explanation isn't complete. Joe has not yet bought his car! Even at the last page of the "Tutorial" there is $150 sitting in his account. So, let's actually finish the process.

Joe withdraws $100 to pay for the car. This depletes the bank's reserves by $100.

So, this is the bank's balance sheet after the loan has been made:

Only two things have changed here. The reserves have dropped by $100 because of the withdrawal. Also, the bank balances has dropped by $100 because of the withdrawal.

The bank's net worth is still the same, it's $200 - $50 = $150.

There are a few things to clear up here. Firstly, why does the bank do this? Well, the loan comes with interest. The bank is hoping to make a profit from the interest.

Secondly, how are reserves reduced when the withdrawal happens? There are several answers and it depends on how the car is paid for. It could be paid for in cash. Now, cash is effectively the same as reserves. The Central Bank will exchange one for the other. If one bank has too much cash then it can send it to the central bank and exchange it for reserves. If it has too little cash it can do the opposite. The two are effectively the same, it's just that cash has a physical form.

Alternatively, the car may be paid for with a bank transfer. Now, interbank transfers are normally done using reserves. Transfers are happening all the time. The banks work out the net of them. They then use reserves to settle that. Since our bank only has one customer the situation is very simple.

Finally, this is why we have a loanable fund market. The reserves are the fuel that the bank uses to make loans. It can obtain that fuel in several different ways firstly by the reverse of what I described above. Reserves come in from people putting cash into accounts and from bank transfers. The come in from people paying off loans. Banks can also borrow reserves from other banks and from the Central Bank.