Commercial banks create money by giving out loans:
NoteThe money created by commercial banks is not physical money (notes and coins), but rather digital money in the form of deposits.
Concept of Credit Creation
- Commercial banks create money through a process called credit creation.
- This occurs when banks lend out a multiple of the deposits they receive, rather than simply lending out the same amount.
- The process expands the money supply in the economy, influencing economic activity and liquidity.
The Money Multiplier & Reserve Requirement
- The money multiplier determines how much money can be generated from an initial deposit.
- It is calculated using the formula:
- $\text{Money Multiplier} = \frac{1}{\text{Minimum Reserve Requirement}}$
- The minimum reserve requirement is the fraction of total deposits that commercial banks must hold as reserves, as mandated by the central bank.
- A lower reserve requirement leads to a higher money multiplier, meaning more money can be created.
- A higher reserve requirement restricts the ability of banks to lend, reducing the money supply.
Initial Deposit:
- A customer deposits $50,000 into Bank A.
Reserve Requirement:
- Suppose the central bank requires a reserve ratio of 10%.
- This means Bank A must keep $5,000 in reserve and can lend out $45,000.
First Loan & Deposit:
- Bank A lends $45,000 to a business for expansion.
- The business deposits the loan into Bank B.
Bank B’s Lending:
- Bank B must keep 10% of $45,000 ($4,500) in reserves.
- The remaining $40,500 is available for lending.
Second Loan & Deposit:
- Bank B lends $40,500 to another individual, who deposits it into Bank C.
- Bank C must hold $4,050 in reserves and can lend out $36,450.
Continuous Process:
- This cycle repeats multiple times, with each bank keeping 10% of deposits as reserves and lending the rest.
Total Money Supply Created:
- The total deposits created in the banking system can be calculated using the money multiplier formula:
- $\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}} = \frac{1}{0.10}$
- The original $50,000 deposit eventually leads to a total money supply of: $10 \times 50,000 = 500,000$
- Thus, \$50,000 in actual cash leads to \$500,000 in total deposits through the process of credit creation.
The money multiplier assumes that all loaned money is redeposited into the banking system and that banks lend out the maximum amount allowed by the reserve ratio.
